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Department of Labor Proposes New Fee Disclosure Standards for Service Providers
by Joseph Semo, Esq.
On December 13, 2007, the Employee Benefits Security Administration of the Department of Labor ("Department") published a proposed rule titled: "Reasonable Contract or Arrangement Under Section 408(b)(2) - Fee Disclosure; Proposed Rule."1 Contemporaneously, the Department proposed a class exemption that provides innocent fiduciaries with a procedure to sidestep liability on their part so long as the fiduciary promptly takes corrective action or, if the service provider fails to cooperate, blows the whistle on the service provider.2 This is a clever pairing. By providing a strong incentive for fiduciaries to promptly call the Department for enforcement (and to the Internal Revenue Service for penalty taxes) arising from any shortcoming in disclosure and establishing a standard of required fee disclosure that the fiduciary must pursue, the Department, as a practical matter, has extended its regulatory reach to service providers.
This much anticipated proposed rule concerning the disclosure of fees received by employee benefit plan service providers was the culmination of several years of investigation by the Department of Labor. In 2004, the Working Group on Fee and Related Disclosures to Participants of the ERISAAdvisory Council on Employee Welfare and Pension Benefit Plans held hearings and explored the adequacy of fee and related disclosures obtained by plan fiduciaries and the adequacy of the fee and related expense disclosures communicated to participants. The Proposed Regulation, though prescribing conduct for plan administrators and fiduciaries, imposes obligations on service providers: service providers who fail to act accordingly expose themselves to liability for prohibited transaction penalties and even criminal liability.3
In recent years, the employee benefit plan community has become increasingly educated on the methods of compensation of plan service providers. Plan sponsors have become alert to the income made by plan service providers directly and indirectly from doing business with plans. In addition to receipt of stated fees, service providers have received additional income in money and other forms of compensation arising from how they provide services. Indirect compensation has been recognized by some service providers from rebates, commissions, override commissions, and management fees. Payment to plan service providers has been made in cash, in research services, and non-monetary forms of compensation, such as prizes, trips, cruises, gifts, and stock awards. The Department has recognized that "the complexity of [changes in the way services are provided to employee benefit plans] has made it more difficult for plan sponsors and fiduciaries to understand what the plan actually pays for the specific services rendered and the extent to which compensation arrangements among service providers present potential conflicts of interest that may affect not only administrative costs but the quality of services provided."4
For some time, the Department of Labor has been attempting to raise awareness among plan sponsors of the need to probe service providers to learn of all forms of compensation being paid. The Department has developed and made available tools for plan sponsors to inquire of all payments made arising from the opportunity to provide services for their plans.5
The Department's interest in this area is rooted in its responsibility to oversee the fiduciary functions of plan administration. Section 406(a)(1)(C) of ERISA6 generally prohibits the furnishing of goods, services, or facilities between a plan and a party in interest to the plan. Aperson providing services to the plan is defined by ERISA to be a "party in interest" to the plan. Consequently, unless an exemption applies, a service relationship between a plan and a service provider would constitute a prohibited transaction. Exemptions to the prohibited transaction rules are provided either by statute or at the discretion of the Department.
Section 408(b)(2) of ERISA provides relief from ERISA's prohibited transaction rules for service contracts or arrangements between a plan and a party in interest if the contract or arrangement is reasonable, the services are necessary for the establishment or operation of the plan, and no more than reasonable compensation is paid for the services. Regulations issued by the Department, and already in force, have established criteria to determine: what arrangements are reasonable;7 what services are necessary;8 and what constitutes reasonable compensation.9 Practitioners drew comfort from the ability to demonstrate that particular contracts and arrangements satisfied the Section 408b standard where a contract or arrangement was entered after a competitive bidding process. The Proposed Regulation takes away that comfort zone, as the selection of a provider that otherwise appears to be the most favorable provider would fail to satisfy the statutory exemption criteria if an element of compensation was not fully and properly disclosed. The Department, however, has provided a correction method for the responsible plan fiduciary who follows the process set forth in the proposed class exemption.
The Proposed Regulation
The Proposed Regulation prescribes the circumstances which must be satisfied in order for a contract or arrangement for covered services to qualify as "reasonable" for Section 408(b)(2). The structure of the Proposed Regulation is to first identify the contracts covered by the proposed rules, and then to identify the minimum fee disclosure requirements which must be obtained by the fiduciary in order to obtain the 408(b)(2) relief from the prohibited transaction rules.
1. Covered Contracts and Arrangements
The Proposed Regulation covers contracts or arrangements for any of the following services (herein, "covered service" or "covered services"):10
(A) Aservice provider who provides or may provide any services to the plan pursuant to the contract or arrangement as a fiduciary either within the meaning of section 3(21) of ERISAor under the Investment Advisers Act of 1940;
(B) Aservice provider who provides or may provide any one or more of the following services to the plan pursuant to the contract or arrangement: banking, consulting, custodial, insurance, investment advisory (plan or participants), investment management, recordkeeping, securities or other investment brokerage, or third party administration; or
(C) Aservice provider who receives or may receive indirect compensation or fees in connection with providing any one or more of the following services to the plan pursuant to the contract or arrangement: accounting, actuarial, appraisal, auditing, legal, or valuation.
2. The Required Disclosures
Contracts or arrangements for the covered services must be in writing and satisfy prescribed disclosure requirements. The terms of the contract or arrangement (including any extension or renewal of such contract or arrangement) must require the service provider to disclose in writing, to the best of the service provider’s knowledge, specific information and must include a representation by the service provider that, before the contract or arrangement was entered into (or extended or renewed), all information required by the Proposed Regulation was provided to the fiduciary with authority to cause the employee benefit plan to enter into (or extend or renew) the contract or arrangement (the "responsible plan fiduciary").
The specific information that must be provided by the service provider to the responsible plan fiduciary includes:11
(A) All services to be provided to the plan pursuant to the contract or arrangement and, with respect to each such service, the compensation or fees to be received by the service provider.12 In addition, a description of the manner of receipt of compensation or fees must express whether the service provider will bill the plan, deduct fees directly from plan accounts, or reflect a charge against the plan investment and must describe how any prepaid fees will be calculated and refunded when a contract or arrangement terminates.
(B) Whether the service provider (or an affiliate) will provide any services to the plan as a fiduciary either within the meaning of section 3(21) of ERISAor under the Investment Advisers Act of 1940,
(C) Whether the service provider (or an affiliate) expects to participate in, or otherwise acquire a financial or other interest in, any transaction to be entered into by the plan in connection with the contract or arrangement and, if so, a description of the transaction and the service provider’s participation or interest therein,
(D) Whether the service provider (or an affiliate) has any material financial, referral, or other relationship or arrangement with a money manager, broker, other client of the service provider, other service provider to the plan, or any other entity that creates or may create a conflict of interest for the service provider in performing services pursuant to the contract or arrangement and, if so, a description of such relationship or arrangement,
(E) Whether the service provider (or an affiliate) will be able to affect its own compensation or fees, from whatever source, without the prior approval of an independent plan fiduciary, in connection with the provision of services pursuant to the contract or arrangement (for example, as a result of incentive, performance-based, float, or other contingent compensation) and, if so, a description of the nature of such
(F) Whether the service provider (or an affiliate) has any policies or procedures that address actual or potential conflicts of interest or that are designed to prevent either the compensation or fees otherwise required to be disclosed or the relationships or arrangements addressed by the Proposed Regulation from adversely affecting the provision of services to the plan pursuant to the contract or arrangement, and, if so, an explanation of these policies or procedures and how they address such conflicts of interest or prevent an adverse effect on the provision of services.
3. Required Updates
The Proposed Regulation requires that the written contract obligate the service provider to identify to the responsible plan fiduciary any material change to the information required to be disclosed by the regulation no later than 30 days from the date on which the service provider acquires knowledge of the material change.13
In addition, the contract must obligate the service provider to disclose all information related to the contract or arrangement and any compensation or fees received under the contract or arrangement that is required by the responsible plan fiduciary or plan administrator in order to comply with disclosure requirements of Title I of ERISA.14
4. Termination of Contract
The Proposed Regulation continues the requirement that the contract or arrangement must be terminable on short notice.15 As under current regulations, a contract or arrangement may provide for a reasonable early termination payment to allow recoupment of reasonable start-up costs.
The Proposed Class Exemption
Standing alone, the Proposed Regulation creates considerable discomfort because a prudent fiduciary who asks all the right questions could nonetheless lose the protection of the statutory exemption if the service provider failed (whether purposely or innocently) to disclose an element of compensation. This concern, however, is addressed by the contemporaneously published proposed class exemption. The PCE would be available to a responsible plan fiduciary who has entered or renewed a contract or arrangement for services that fails to meet the "reasonable contract or arrangement" standard due to the service provider’s failure to comply with its contractual obligation to disclose the information required by the disclosure obligations of the Proposed Regulation. The service provider would continue to be subject to sanctions for engaging in a prohibited transaction imposed by Internal Revenue Code §4975(a).
In order to obtain the relief provided by the PCE, the responsible fiduciary must meet the following conditions:16
- The responsible plan fiduciary, taking into account all of the information available at the time the contract or arrangement was entered into, extended or renewed, reasonably believed that the contract or arrangement met the requirements of the Proposed Regulation and did not know, or have reason to know, that the service provider failed or would fail to comply with its disclosure obligations;
- The responsible plan fiduciary, upon discovering that the service provider failed to comply with its disclosure obligations, must, if it has not already received the information that the service provider failed to disclose under its disclosure obligations, request in writing that the service provider furnish the information;
- If the service provider fails to comply with the plan fiduciary's written request for the information that the service provider failed to disclose earlier within 90 days of the date of its request, the responsible plan fiduciary within 30 days thereafter must notify the Department of Labor of the service provider’s failure;17 and
- The responsible plan fiduciary, following discovery that the service provider failed to comply with its disclosure obligations, shall determine whether to terminate or continue the contract or arrangement. The responsible plan fiduciary will evaluate the nature of the particular disclosure failure and determine the actions necessary under the facts and circumstances. Such fiduciary shall consider, among other factors, the availability, qualifications and costs of potential replacement service providers, and the responsiveness of the service provider in furnishing the information that the service provider should have disclosed, but did not, under its disclosure obligations.
Expected Praise and Criticism of the Proposed Regulation and Proposed Class Exemption
1. Expected Concerns from Service Providers
The Proposed Regulation creates uncertainty for the responsible plan fiduciary and plan sponsor who discover a disclosure failure by the service provider and must evaluate what obligation result from the late disclosure. Consider the following example:
The service provider, an insurance consultant, provides consulting services for a flat fee. In connection with obtaining policies for the plan, the insurance consultant acts as broker and waives commission. Though no commission is charged by the insurance consultant or its affiliated brokerage through which the insurance is obtained for the particular policies placed for the plan, based upon the aggregate policies written with a particular carrier, the insurance consultant's affiliated brokerage firm receives an override commission.
In this case the override commission is a form of "compensation." Disclosure would appear to have been required by the Proposed Regulation even if no portion of the override was attributable to the policy obtained by the plan and required to be reported on Form 5500 Schedule A.18 Disclosure in this case would be required if it would be material to evaluating the recommendation by the insurance consultant of a particular carrier among others.
In this example, if the responsible plan fiduciary determines that there was a disclosure failure, he or she could make a specific inquiry of the insurance consultant for the details. If the insurance consultant refuses or fails to provide the information, the responsible plan fiduciary would have to file a notice with the Department in order to protect itself from prohibited transaction liabilities. On the other hand, if the insurance consultant instead provides the requested information, the responsible plan fiduciary must determine what actions to take. If the responsible plan fiduciary, after consideration of all the information, determines that the additional information does not require any further action, it is unclear whether it must nonetheless disclose a prohibited transaction in its Form 5500 filing. Presumably, in this case the Proposed Regulation would have required disclosure as the information was properly taken into account in evaluating the vendors even if the information was not outcome-determinative. As a result, it would seem that a prohibited transaction occurred because the plan entered an arrangement that is deemed unreasonable as a result of the failure to provide the fiduciary with the requisite information, even though the amount involved would appear to be zero. In this situation, the Department might wish to clarify that the failure would not need to be classified as resulting in a prohibited transaction.
2. Expected Concerns for Participant Directed Arrangements
To the extent that the regulatory project was encouraged to assist participants to wisely manage their individual accounts in defined contribution plans, the regulations is likely to result in the development of an industry standard that will: deem certain expense information "material"; evolve a format for disclosure that will be uniform to enhance apples-to-apples comparisons; and enable plan sponsors to provide participants with access to such information timely, and in a manner where the plan sponsor will be comfortable that it is not exposing itself to liability for passing-through such information.
Also, Participant rights advocates will complain that the Proposed Regulation falls short because it does not require that the plan sponsor provide the expense information to participants even in participant directed investment plans, nor does it mandate a format of disclosure of such information.
3. Expected Concerns of Service Providers
As the regulation is directed to the responsible plan fiduciary, compliance may prove to be a challenge for hedge fund sponsors who agree to accept fiduciary responsibility for ERISAassets entrusted to them. One should anticipate that hedge fund sponsors, particularly fund-of-funds managers, will seek relief as in many cases they may not be able to access in any verifiable manner all elements of compensation obtained by the sub-managers the select.
The Proposed Regulation should prove helpful to plans and participants, so that each better understands the charges associated with services. Plans and their service providers will benefit by carefully considering the unexpected reach of the Proposed Regulation and the obstacles to collecting information across multi-service organizations. However, failure of Plans and their service providers giving sufficient consideration to the implementation of the Proposed Regulation is likely to lead to many difficulties in implementation of compliance efforts.
1 Reasonable Contract or Arrangement Under Section 408(b)(2) – Fee Disclosure, 72 Fed. Reg. 70988 (proposed Dec. 13, 2007) (to be codified at 29 C.F.R. pt 2550) ("Proposed Regulation").
2 Proposed Class Exemption for Plan Fiduciaries When Plan Service Arrangements Fail to Comply with ERISASection 408(b)(2), 72 Fed. Reg. 70893 (proposed Dec. 13, 2007)("PCE").
3 Awide net is cast by the reach of 18 U.S. C. §664, which protects the interests of employee benefit plans.
4 72 Fed. Reg. 70988 (Dec. 13, 2007).
5 See http://www.dol.gov/ebsa/pdf/401kfefm.pdf. This model form was developed jointly by the American Bankers Association, the Investment Company Institute, and the American Council of Life Insurers.
6 "ERISA" means the Employee Retirement Income Security Act of 1974, as from time-to-time amended.
7 29 C.F.R. §2550.408b-2(c).
8 29 C.F.R. §2550.408b-2(b).
9 29 C.F.R. §2550.408b-2(d).
10 Proposed Regulation, §2550.408b-2(c)(1)(i)(A) – (C), 72 Fed. Reg., at p.71004.
11 Proposed Regulation, §2550.408b-2(c)(1)(iii)(A) – (F), 72 Fed. Reg., at p.71004-71005.
12 The Proposed Regulation contains the following definition for "compensation or fees":
(1) "Compensation or fees" include money or any other thing of monetary value (for example, gifts, awards, and trips) received, or to be received, directly from the plan or plan sponsor or indirectly (i.e., from any source other than the plan, the plan sponsor, or the service provider) by the service provider or its affiliate in connection with the services to be provided pursuant to the contract or arrangement or because of the service provider's or affiliate's position with the plan. An "affiliate" of a service provider is any person directly or indirectly (through one or more intermediaries) controlling, controlled by, or under common control with the service provider, or any officer, director, agent, or employee of, or partner with, the service provider.
(2) Compensation or fees may be expressed in terms of a monetary amount, formula, percentage of the plan's assets, or per capita charge for each participant or beneficiary of the plan. The manner in which compensation or fees are expressed shall contain sufficient information to enable the responsible plan fiduciary to evaluate the reasonableness of such compensation or fees.
(3) If a service provider offers a bundle of services to the plan that is priced as a package, rather than on a service-by-service basis, then only the service provider offering the bundle of services must provide the disclosures required by this paragraph (c)(1). The service provider must disclose all services and the aggregate compensation or fees to be
received, directly or indirectly, by the service provider, any affiliate or subcontractor of such service provider, or any other party in connection with the bundle of services. The service provider shall not be required to disclose the allocation of such compensation or fees among its affiliates, subcontractors, or other parties, except to the extent such party receives or may receive compensation or fees that are a separate charge directly against the plan’s investment reflected in the net value of the investment or that are set on a transaction basis, such as finder’s fees, brokerage commissions, and soft dollars (research or other products or services other than execution in connection with securities transactions).
Proposed Regulation, §2550.408b-2(c)(1)(iii)(A), 72 Fed. Reg., at p.71004-71005.
13 Proposed Regulation, §2550.408b-2(c)(1)(iv), 72 Fed. Reg., at p.71005.
14 Proposed Regulation, §2550.408b-2(c)(1)(v), 72 Fed. Reg., at p.71005.
15 Proposed Regulation, §2550.408b-2(c)(2), 72 Fed. Reg., at p.71005.
16 PCE, Section II, 72 Fed. Reg., at p. 70896.
17 The following information must be provided to the Department: (i) The name of the plan; (ii) the three digit plan number used for the plan’s Annual Report; (iii) the plan sponsor's name, address, and EIN; (iv) the name, address, and telephone number of the responsible fiduciary; (v) the name, address, phone number, and, if known, EIN of the service provider; (vi) a description of the services provided to the plan; (vii) a description of the information that the service provider failed to furnish; (viii) the date on which such information was requested in writing from the service provider; and (ix) a statement as to whether the service provider continues to provide services to the plan.
18 See ERISAAdvisory Opinion 2005-02Afor a discussion of how certain payments to brokers should be reported.
Joseph Semo, Esq.
Mr. Semo provides comprehensive guidance on compensation arrangements in addition to a general business practice. Representative engagements include:
Counseling on executive compensation arrangements.
Evaluation of deferred compensation arrangements under Internal Revenue Code §409A.
EMPLOYEE BENEFIT PROGRAMS
Representation of plan sponsors and plan fiduciaries in all aspects of employee benefits including plan design (pension, welfare, and non-qualified compensation plans), compliance issues (tax and labor), multi-employer plan representation, institutional investment issues (e.g. security lending agreements, investment management agreements, and third-party administration contracts), prohibited transaction exemptions, multiple employer welfare plan issues, and provider contracts.
Conduct internal investigation of corporate stock transactions to determine whether distributions of stock and other equity interests to employees were executed consistent with terms of agreement with venture capital investors.
Since 1984, Mr. Semo has been a member of the City of Annapolis Police and Fire Retirement Plan Commission and serves as its Chairman. During that time, the investments of the retirement plan moved from guaranteed insurance contracts to a fully diversified investment program.
Mr. Semo received his undergraduate degree from the Wharton School of the University of Pennsylvania and his law degree from George Washington University. He is a member of the bar of the District of Columbia, Maryland, Virginia and Wisconsin. He is admitted to numerous federal district courts, Circuit Courts and the United States Supreme Court. Mr. Semo received an honorable discharge from the U.S. Army Reserve, achieving the rank of Captain, Quartermaster Corps.
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