On February 2, the Department of Labor finally issued long-anticipated final regulations requiring retirement-plan service providers to disclose to employer-plan sponsors all of their direct and indirect compensation and potential conflicts of interest. The requirements put both the plan sponsors and investment management fiduciaries (often CFOs) in a conundrum.
Under the regulations, now slated to take effect on July 1, service providers must make the new disclosures in order to qualify for an important statutory exemption under ERISA Section 408(b)(2). The exemption allows them to avoid having a contract or other arrangement with a plan sponsor characterized as a prohibited transaction that would make the provider subject to excise taxes. More notably, from an employer’s viewpoint, the exemption also enables plan sponsors to avoid potential breach of fiduciary liability resulting in litigation.
But the rules are very cumbersome and difficult to comply with, and compliance is based on service-provider information that may not be accurate. Moreover, the onus is on the plan sponsor and its investment-management fiduciary to determine the “reasonableness” of service providers’ direct and indirect compensation in order to qualify for the exemption.
In addition, the “responsible plan fiduciary” prohibited transaction exemption depends on the fiduciary not knowing the service provider failed to make the required disclosures and that the fiduciary “reasonably believed” such disclosures were made.
Discovery of a disclosure failure requires the responsible plan fiduciary to notify the DoL. That puts the fiduciary in a “Catch-22,” because such disclosure failures often result in the discovery of “revenue sharing” between the service provider and its subadvisers. That affects the fiduciary’s determination of “reasonableness” of compensation. It also highlights the fiduciary’s failure to prudently monitor and avoid the payment of excessive compensation from investments in participant-directed accounts.
The burden of having “reasonably believed” that service providers disclosed the requisite information is of great concern. The exemption should not be based on whether a responsible plan fiduciary can recognize disclosure omissions or errors. The exemption should be available if the fiduciary did not “know or have reason to know” that a service provider failed to make required disclosures.
However, the DoL decided that responsible plan fiduciaries should not be entitled to the relief provided by the exemption if they don’t have a reasonable belief that all required disclosures are complete. Further, the DoL said, responsible plan fiduciaries should appropriately review the disclosures made by service providers. Moreover, the DoL emphasized that fiduciaries “should be able to, at a minimum, compare the disclosures they receive from a covered service provider to the requirements of the regulation and form a reasonable belief that the required disclosures have been made.”
Making that comparison, and then having to “form a reasonable belief” that the appropriate disclosures have been made, is a very high standard for plan fiduciaries to achieve. In effect, it requires them to retain experts working under the direction of independent counsel to ascertain compliance with the regulations and identify all “hidden” fees, so that the lack of monitoring remains confidential and fiduciaries thereby avoid being sued by the DoL or participants.
The rest of this article fleshes out some of the points made above.
ERISA’s Prohibited Transaction Requirements
The furnishing of goods, services, or facilities between a plan and a party in interest to the plan generally is a prohibited transaction under ERISA 406(a)(1)(C). As a result, a service relationship between a plan and a service provider constitutes a prohibited transaction, because any person providing services to the plan is defined by ERISA to be a “party in interest” to the plan.
However, ERISA 408(b)(2) exempts certain arrangements between plans and service providers that otherwise would be prohibited. To qualify for that relief, though, the contract or arrangement must be “reasonable,” the services must be necessary for the plan’s establishment or operation, and no more than “reasonable compensation” is paid for the services.
The regulations define a responsible plan fiduciary as one with authority to cause the plan to enter into, extend, or renew a contract or arrangement for the services. And where a service provider fails or refuses to furnish the requested information, the prudence requirements of ERISA 404 preclude the responsible plan fiduciary from entering into (or continuing) the service contract or arrangement.
Exemption for Responsible Plan Fiduciary
The final regulations permit a responsible plan fiduciary to avoid engaging in a prohibited transaction when a service provider fails to disclose required information.
Specifically, the exemption is available if the fiduciary did not know that the covered service provider failed to make required disclosures and “reasonably believed” that such disclosures were made. Upon discovery of a disclosure failure, the responsible plan fiduciary must take certain specified steps within designated time frames, including notifying the DoL of any disclosure failures that are not corrected.
The exemption provides relief to a responsible plan fiduciary from the prohibited transaction restrictions, notwithstanding any failure by a covered service provider to comply with its disclosure obligations, provided that certain conditions are met.
One condition is that the responsible plan fiduciary did not know that the service provider failed or would fail to make required disclosures and reasonably believed that the covered service provider disclosed the information required by the final regulations. Another condition requires that, upon discovering that the service provider failed to disclose the required information, the responsible plan fiduciary must request in writing that the covered service provider furnish such information.
If the service provider fails to comply with the responsible plan fiduciary’s written request within 90 days, the regulations require that the responsible plan fiduciary notify the DoL. The DoL “believes that this condition, along with a covered service provider’s exposure to excise tax liability under the Code, will provide covered service providers with a sufficient incentive to address disclosure failures within a reasonable time.”
However, it is important to note that the notice requirement does not relieve the employer plan sponsor of the obligation to report a prohibited transaction in accordance with the instructions to the Annual Report Form 5500 Series, without regard to whether the service provider furnishes information in response to the fiduciary’s request.
Lastly, the final regulations require the responsible plan fiduciary, following the discovery of a failure to disclose, to determine the extent to which the contract or arrangement at issue can be continued consistent with the fiduciary’s duty of prudence under ERISA Section 404. That regulation assumes that plan fiduciaries will take into account certain factors in making such determinations, such as the nature of the failure and the availability and costs of a replacement service provider.
Although this affords the responsible plan fiduciary some flexibility in securing replacement services, the DoL emphasizes that “it is not intended to permit fiduciaries to continue contracts or arrangements indefinitely when there has been an unresolved disclosure failure.”
In this regard, the final regulations provide that the prudence provisions of ERISA 404 govern determinations in this area. Thus, the regulations require that if the requested information relates to future services and is not disclosed promptly after the end of the 90-day period, then the responsible plan fiduciary must terminate the contract or arrangement as expeditiously as possible, consistent with the duty of prudence.
Imposition of Excise Taxes
If a service provider fails to disclose the information required by the final regulations, then the contract or arrangement will not be “reasonable” and will not qualify for relief from the prohibited transaction rules.
According to the DoL, the resulting prohibited transaction will have consequences for the responsible plan fiduciary as well as the service provider. The fiduciary, by causing the transaction, will have violated ERISA 406(a)(1)(C) and (D). The service provider, as a “disqualified person” under the Code’s prohibited transaction rules, will be subject to the excise taxes that result from the service provider’s participation in a prohibited transaction.
Code Section 4975(a) provides that the rate of the excise tax is 15% of the “amount involved” with respect to the prohibited transaction for each year (or part) in the taxable period. The Code goes on to provide in Section 4975(b) that if the prohibited transaction is not corrected within the taxable period, the rate of the excise tax increases to 100% of the “amount involved.”
As noted above, however, the DoL does not believe that an otherwise diligent responsible plan fiduciary should be penalized as a result of a failure on the part of a service provider to make the required disclosures. Accordingly, the final regulation includes the exemptive relief described above.
However, the exemptive relief is difficult to achieve, since the responsible plan fiduciary must demonstrate a “reasonable belief” that service providers disclosed the requisite information. Moreover, as a condition of that exemptive relief and more generally under the prudence requirements of ERISA 404, a responsible plan fiduciary must, following its discovery that a provider failed to disclose required information, consider what steps should be taken in response. In certain circumstances, the fiduciary may have to terminate the contract or arrangement with the service provider.
Jeff Mamorsky is co-chair of the global benefits practice at law firm Greenberg Traurig.