The U.S. Department of Labor (“DOL”) has proposed (another) attempt to redefine the term “fiduciary” under ERISA. This proposal would have significant implications across the retirement  and financial services industry.

This proposal – and the implications—are bigger than just one blog post. So, consider this post the first installment in analyzing this new proposal.

Background

ERISA fiduciaries are held to an extraordinarily high standard of conduct—they must act for the “exclusive benefit” of plan participants. Consistent with this high standard of conduct, in the absence of a regulatory exemption financial professionals would be prohibited from engaging in many types of “typical” financial transactions—most notably, transactions where a financial professional receives commission-based compensation such as for sale of insurance or securities. Correspondingly, under the Internal Revenue Code fiduciaries must pay an excise tax for entering into prohibited transactions.

Accordingly, the underlying definition of who is a “fiduciary” is of outsized importance to ERISA plan sponsors and to the financial services industry.

ERISA contains several different definitions of “fiduciary” (covering different types of services). For purposes of defining an investment fiduciary —and the new DOL proposal–the relevant provision of ERISA states:

“a person is a fiduciary with respect to a plan to the extent … he 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…”

The trouble with this definition started in 1975—the year after ERISA was enacted. In 1975 (before the 401(k) plan was invented and when most retirement benefits were paid in the form of annuities from defined benefit plans) the DOL issued regulations that narrowly defined who was an investment fiduciary. The 1975 regulation included a five-part test to determine whether a person was a fiduciary and this test had many caveats and exceptions – so that much important financial advice was provided by persons who could easily disavow their fiduciary responsibility.

The DOL identified concerns with the five-part test in 2010 and has been trying to address these concerns since then. Most significantly, in 2016 the DOL issued a regulation redefining the term “investment fiduciary.” However, that 2016 regulation was struck down in the courts. The new proposed regulations represent the DOL’s latest effort to address concerns over the gaps in the 1975 regulation.

Context

Before diving into the new proposed regulations, some context:

• The definition of “fiduciary” is important because, in effect, it defines the scope of the DOL’s authority to regulate behavior. Fiduciaries seeking to sell a product or enter into a transaction with a plan or a plan participant must do so under DOL’s rules providing exemptions to ERISA’s expansive prohibited transaction rules—entities that are not fiduciaries are much freer to act without constraints.

Accordingly, the other key aspect of this regulatory package is a series of updates to DOL guidance governing how fiduciaries can enter into (otherwise prohibited) transactions. Most significantly, the DOL has is also updating Prohibited Transaction Exemption 2020-02 containing rules allowing service providers to receive otherwise prohibited compensation for investment advice.

• The DOL has sought to create a definition of investment fiduciary that is based on the nature on the advice rendered that is agnostic as to the products being sold—the definition applies equally to persons selling securities, insurance, annuities, commodities, real estate, or anything else. In issuing this rule the DOL notes that other regulators (such as the SEC) have issued their own rules for the professionals subject to each such other regulator’s jurisdiction — and that there are different standards applicable to  different financial professionals (e.g., securities vs insurance sales). In issuing this new proposal the DOL has staked out the position that there should be a consistent definition of investment fiduciary applicable to all ERISA plans (regardless of the product sold) and, correspondingly, a consistent standard of conduct governing permitted transactions.

• Similarly, the DOL has sought to create a definition that applies across the board to all potential recipients of investment advice—plan sponsors, individual plan participants and IRA owners.

• The most significant gap that the DOL is seeking to fill regards advice given to a participant in an employer sponsored plan about whether to roll over a distribution to an IRA. These transactions do not trigger fiduciary status under the 1975 five-part test and yet they are often the single most important investment-related decision made by individuals. The DOL views this exclusion as a major gap and views the new proposal as a way to close the gap.

The New Definition

Under the DOL’s new proposed regulation:

“a person renders “investment advice” with respect to moneys or other property of a plan or IRA if the person makes a recommendation of any securities transaction or other investment transaction or any investment strategy involving securities or other investment property … to the plan, plan fiduciary, plan participant or beneficiary, IRA, IRA owner or beneficiary or IRA fiduciary (retirement investor), and the person … either directly or indirectly …makes investment recommendations to investors on a regular basis as part of their business and the recommendation is provided under circumstances indicating that the recommendation is based on the particular needs or individual circumstances of the retirement investor and may be relied upon by the retirement investor as a basis for investment decisions that are in the retirement investor’s best interest…”

Prop. Reg. 29 C.F.R. Section 2510.3-21(c)(1)(ii), emphasis added.

Rather than providing regular advice to the recipient (as was required under the 1975 five-part test) the new rule focuses on whether the provider “makes investment recommendations to investors on a regular basis as part of their business.” Also, rather that requiring that advice be the primary basis for an investment decision (also, a part of the 1975 five-part test) the new rule focuses on whether the advice is given “under circumstances indicating that the recommendation is based on the particular needs or individual circumstances of the retirement investor and may be relied upon by the retirement investor as a basis for investment decisions that are in the retirement investor’s best interest.”

(The proposed regulation includes other activities in the definition of “fiduciary” — including if a person either directly or indirectly “has discretionary authority or control, whether or not pursuant to an agreement, arrangement, or understanding, with respect to purchasing or selling securities or other investment property” and when the person making the recommendation “represents or acknowledges that they are acting as a fiduciary when making investment recommendations”. These alternative definitions are important—but more straightforward than paragraph (c)(1)(ii) described above

To further convey the intended breadth of the new proposal, the DOL defines “recommendation” very broadly, including recommendations:

• As to the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, as to investment strategy, or as to how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
• As to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., account types such as brokerage versus advisory) or voting of proxies appurtenant to securities; and
• As to rolling over, transferring, or distributing assets from a plan or IRA, including recommendations as to whether to engage in the transaction, the amount, the form, and the destination of such a rollover, transfer, or distribution.

What Next

The DOL has provided a 60-day comment period. Although we typically do not predict regulatory outcomes, recent events have followed a pattern and, if this pattern prevails:

• We can expect a flurry of comments, especially from affected service providers.

• Following the comment period, the DOL will finalize the new proposal. The DOL has taken a lot of time to construct this proposal—so we anticipate that the DOL’s response to the comments will be to tweak the proposal around the edges—but not make dramatic changes.

• The proposed regulations will draw opposition from the same groups that opposed the 2016 rules. The opposition is already starting—see statement from U.S. Chamber of Commerce. Accordingly, one can anticipate that the final regulations will be challenged in court—most likely in the Fifth Circuit (covering Louisiana, Mississippi, and Texas). This court has been especially unfriendly to regulatory initiatives and the plaintiffs will engage in “forum shopping” to find a receptive court. Indeed, it would seem the DOL is anticipating a legal challenge—the 250+ page preamble already seems to contain the outline of the DOL’s legal arguments in support of the proposal.

As noted, the DOL has been wrestling with the issues raised in this proposal since 2010. We do not expect this cage match will end any time soon.