DOL Issues Proposed Regulations Requiring Disclosure of Service Provider Fees and Conflicts of Interest
On December 13, 2007, the Department of Labor (“DOL”) issued proposed regulations under Section 408(b)(2) of the Employee Retirement Income Security Act of 1974 (“ERISA”) that would require plan service providers to provide more comprehensive written disclosure to the plan fiduciary who has authority on behalf of the plan to enter into an arrangement with the service providers. This includes disclosure of information regarding the compensation the service provider would receive, either directly or indirectly, and any conflicts of interest that may arise in connection with the provision of services to the plan. See 72 Fed. Reg. 70988, 12/13/07. In conjunction with the proposed regulation, the DOL also issued a proposed class exemption that would provide relief to a plan fiduciary for engaging in a prohibited transaction if, unknown to the plan fiduciary, the service provider should fail to comply with the disclosure requirements under the proposed regulation. See 72 Fed. Reg. 70893, 12/13/07.
These regulations would be effective 90 days after the publication of the final regulations. The DOL requested comments on the proposed regulations. Based on the volume of comments (over 90), the proposed regulations’ complexity, and their potential for significantly effecting the provision of services to plans, the DOL announced that it has scheduled public hearings in March to assist it in understanding the issues involved.
In recent years fee disclosure issues have been at the forefront of the debate on the effect of fees on retirement benefits. Several class action lawsuits have been filed involving claims of breach of fiduciary duty under ERISA for charging excessive fees and failing to fully disclose fees charged. At least three bills are pending in Congress which are intended to address a perceived gap in information and conflict of interest issues. The DOL’s proposed regulations are another attempt to address these plan fee issues.
Although current law does not specifically require that service providers disclose information regarding fees to plan fiduciaries, in fulfilling its duties under ERISA section 404, a plan fiduciary must have sufficient information to determine if it is acting prudently and solely in the interest of the plan participants and for the exclusive purpose of providing benefits and defraying reasonable expenses of plan administration. In addition, Section 406(a)(1)(C) of ERISA prohibits the furnishing of goods, services, or facilities between a plan and a party in interest to the plan (defined under ERISA section 3(14) to include service providers). ERISA section 408(b)(2), however, provides a statutory prohibited transaction exemption for contractual arrangements between plans and service providers as long as the contract or arrangement is reasonable, the services are necessary for the plan’s establishment or operations, and no more than reasonable compensation is paid for the services. The DOL’s proposed regulations define a reasonable contract or arrangement primarily in terms of the disclosure requirements it must contain.
The Proposed Disclosure Requirements
In order for a contract or arrangement to be reasonable under the proposed regulations, any contract or arrangement (or its renewal or extension) between a plan and certain service providers must require the service provider to disclose the compensation it will receive, directly or indirectly, and any conflict of interest that may arise in connection with its services to the plan.
The proposed regulations impose disclosure requirements on three specific types of service providers:
- those who provide services as fiduciaries under ERISA or the Investment Adviser’s Act of 1940 (“Adviser’s Act”);
- those who perform banking, consulting, custodial, insurance, investment advisory, investment management, recordkeeping, securities or other investment brokerage, or third party administration services; and
- those who receive indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal or valuation services.
While the scope of the proposed regulation is limited to these three types of service providers, the DOL cautions in the preamble to the regulation that general fiduciary obligations under ERISA, as well as the existing requirements under ERISA section 408(b)(2), continue to apply to the selection and monitoring of all service providers. Further, the proposed requirements would apply only to contracts or arrangements for services to plans themselves, and not to contracts or arrangements with entities that merely provide plan benefits to participants and beneficiaries.
For a contract or arrangement for services to a plan to be considered reasonable:
- the terms of the contract must be in writing, to the best of the service providers knowledge;
- the terms must disclose specific information required by the proposed regulations;
- the terms must require that the service provider disclose to plan fiduciaries any “material” changes to the specific information required within 30 days of acquiring knowledge of the change; the preamble defines “material” as being information that “would be viewed by a reasonable plan fiduciary as significantly altering the “total mix” of information made available to the fiduciary, or as significantly affecting a reasonable plan fiduciary’s decision to hire or retain the service provider;”
- the terms must require that the service provider disclose all information related to the contract or arrangement, and any compensation or fees received, that is requested by the responsible plan fiduciary in order to comply with filing requirements under Title I of ERISA;
- the service provider must actually comply with its disclosure obligations; and
- the plan must be allowed to terminate the arrangement without penalty to the plan on reasonably short notice, to prevent the plan from being locked into an arrangement that has become disadvantageous.
The disclosure requirements can be satisfied by use of electronic format or by disclosure in multiple documents from multiple sources. There is no designated time period for the disclosure, but the preamble states that this information should be provided sufficiently in advance of entering into the contract or arrangement for the responsible plan fiduciary to have a reasonable amount of time to prudently consider the information. The contract should also include a representation that, before the contract was entered into, all required information was provided to the responsible plan fiduciary.
Compensation and Fee-Related Disclosures
In advance of entering into a contract or arrangement, the service providers in any of the covered categories described above would be required to provide to plan fiduciaries written disclosure of the following information related to compensation and fees:
- all services provided to the plan under the contract or arrangement;
- the compensation or fees to be received by the service provider for each service; and
- the manner in which the compensation or fees would be received.
The proposed regulations broadly define compensation or fees to include money or any other thing of monetary value, such as gifts, awards, finder’s fees, commissions, 12b–1 fees, soft dollar and “float” income received or to be received by the service provider or its affiliate directly from the plan or plan sponsor, as well as any indirect compensation received from a party other than the plan, plan sponsor or service provider. An affiliate of a service provider includes any person directly or indirectly controlling, controlled by, or under common control with the service provider, as well as any officer, director, agent, employee, or partner of the service provider.
The proposed regulations also provide that the compensation or fee can be expressed in terms of a formula, asset charge, or per capita charge, as long as the description permits the responsible plan fiduciary to evaluate the reasonableness of the compensation or fee.
The proposed regulations would require that providers of bundled services disclose all of the services and, with two exceptions, the aggregate compensation or fees received in connection with the bundle of services. The submission of separate compensation information would be required:
- where a party receives fees that are a separate charge directly against the plan’s investment reflected in the net value of the investment, such as management fees paid by mutual funds to their investment advisers, float revenue and 12b–1 distribution fees; and
- where fees are set on a transaction basis, such as finder’s fees, brokerage commissions, and soft dollars, even if they are paid from mutual fund management fees or similar fees.
The required description of the manner of receipt of compensation would involve stating whether the service provider will bill the plan, deduct fees directly from the plan’s account, or reflect a charge against the plan investment. The service provider would also have to explain how any prepaid fees would be calculated and refunded upon contract termination.
Conflict of Interest Disclosures
The proposed regulations also require the disclosure of certain information regarding potential service provider conflicts of interest. In the preamble to the proposed regulation, the DOL notes the importance of knowing service provider relationships and indirect sources of compensation because of the impact these relationships may have on the manner in which the service provider provides services for the plan. The required information to be provided to the plan fiduciary by the service provider or affiliate includes:
- whether the service provider will provide any services to the plan as a fiduciary under ERISA or the Adviser’s Act;
- whether the service provider expects to participate in or acquire a financial or other interest in any transaction to be entered into by the plan in connection with the contract and, if so, a description of the transaction and the service provider’s participation or interest;
- whether the service provider has any material financial, referral or other relationship with a money manager, broker, other client of the service provider, other service provider of the plan, or any other entity that could create a conflict of interest for the service provider in providing services under the contract and, if so, a description of relationship;
- whether the service provider will be able to affect its own compensation or fees without the prior approval of an independent plan fiduciary in connection with the provision of services under the contract and, if so, a description of the nature of such compensation; and
- whether the service provider has any policies or procedures designed to prevent either the compensation or fees, or the relationships or conflicts, of the types described above from adversely affecting the provision of services under the contract to the plan and, if so, an explanation of these policies and procedures.
Should the contract or arrangement fail to require disclosure of the information or should the service provider fail to disclose the required information, then the contract or arrangement would not be “reasonable”, and therefore, the contract would not provide ERISA section 408(b)(2) relief to the plan fiduciary from the ERISA section 406(a)(1)(C) prohibited transaction rules. Furthermore, the service provider, as a “disqualified person”, would be subject to excise taxes under Internal Revenue Code section 4975. As noted above, the DOL has also proposed a prohibited transaction class exemption which would provide relief from ERISA section 406(a)(1)(C) to a plan fiduciary that reasonably believes the service provider has complied with the disclosure requirements and has no reason to know that the service provider has failed to comply with such disclosure requirements. Under the proposed class exemption, if a plan fiduciary discovers that a service provider failed to disclose required information, the fiduciary must request that information in writing. If the information is not provided within 90 days of that request, the plan fiduciary then has 30 days to notify the DOL. The fiduciary must then determine whether to terminate or continue the contract with the service provider.
Comments and DOL Response
As expected, the proposed regulations have generated a significant number of comments. DOL officials have recently noted that the biggest issue facing the Department as it evaluates comments on the proposed regulations is resolving the question of whether mutual fund investments are covered under the proposed regulations because mutual funds are not considered to hold plan assets and are, therefore, not governed under ERISA. Commentators have suggested that it would be appropriate to consider mutual funds to be indirect service providers that should be covered under the proposed regulations. Service providers have also expressed concerns about the feasibility of complying with the complex regulation’s proposed 90-day effective date once the DOL publishes its final regulations and the fact that a primary service provider must provide fee information to the plan fiduciary but cannot guarantee the information from other service providers. Commentators have also expressed concerns about the specific written disclosure requirements, about disclosure requirements for bundled service providers, and about transition issues for existing contracts. Other questions have arisen with regard to who is a service provider, how far that service provider status extends, and what the liabilities between the parties are if the disclosure requirements are not properly met. On February 14, 2008, Rep. George Miller and Sen. Edward M. Kennedy told the DOL that its proposed fee disclosure regulations needed to go much further in terms of required disclosures of fees, and stated that they would continue to pursue more comprehensive legislation regarding fee disclosures in Congress.
Given the tension between Congress’ desire to require greater transparency with regard to 401(k) fees and concerns by service providers as to the feasibility of properly complying with the regulations when they are finalized, there is no doubt that fee disclosure issues will continue to dominate the regulatory landscape in the coming months.