DOL Issues Proposed Regulations on Fee and Conflict of Interest Disclosures by Service Providers

Employee Benefits Alert
12.19.07

On December 13, 2007, the Department of Labor (DOL), Employee Benefits Security Administration, published new proposed regulations under ERISA Section 408(b)(2) to require more comprehensive written disclosure by service providers to ERISA retirement and welfare plan fiduciaries concerning the service providers’ compensation and any potential conflicts of interest. The DOL also published a proposed class exemption that would provide relief from the prohibited transaction rules for a plan fiduciary under certain circumstances if the service provider fails to comply with its disclosure obligations under the proposed regulations.

The proposed regulations are likely to have a significant impact on service providers and plan sponsors of both pension and welfare plans. The proposed regulations and class exemption would be effective 90 days after publication of the final regulations, which are anticipated late in 2008. Comments are due by February 11, 2008.

Background

As noted in the preamble, the proposed regulations grow out of DOL concerns that changes in the way services are provided to plans have 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.” Plan fiduciaries have a duty under ERISA Section 404(a)(1) when selecting or monitoring plan service providers to act prudently and solely in the best interest of the plan’s participants and beneficiaries. According to the DOL, “fundamental to the fiduciary’s ability to discharge these obligations is the availability of information sufficient to enable the fiduciary to make informed decisions about the services, the costs, and the service provider.”

This is the second of three regulatory projects the DOL has announced to address the issue of fee disclosures:

  • On November 16, 2007, the DOL published final revisions to Form 5500 that will be fully effective by the 2009 reporting year. The revisions to Schedule C “Service Provider Information” add a requirement for detailed disclosure of fees paid directly or indirectly to plan service providers.
  • This most recent proposal focuses on additional disclosure by service providers to plan fiduciaries.
  • The final regulatory project will govern plan disclosures to participants under the ERISA Section 404(c) regulations and is expected in the next several months.

Statutory Framework

ERISA Section 406(a)(1)(C) generally prohibits the furnishing of goods, services, or facilities between a plan and a party in interest to the plan. Because a person providing services to a plan is considered a party in interest to the plan under ERISA Section 3(14)(B), the relationship between the service provider and the plan would constitute a prohibited transaction absent an exemption. ERISA Section 408(b)(2) provides an exemption from the 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. The proposed rulemaking would amend the regulations under Section 408(b)(2) to clarify the meaning of a “reasonable” contract or arrangement. As amended, § 2550.408b-2(c)(1) would require that, in order to be reasonable, any contract or arrangement between an employee benefit plan and certain service providers must require the service provider to disclose the direct or indirect compensation it will receive and any conflicts of interest that may arise in connection with its services to the plan.

Scope

Proposed regulation § 2550.408b-2(c)(1)(i) describes the three categories of service providers subject to the new disclosures:

  • Service providers that are fiduciaries under either ERISA or the Investment Advisors Act of 1940;
  • Service providers who provide banking, consulting, custodial, insurance, investment advisory (plan or participants), investment management, recordkeeping, securities or other investment brokerage, or third party administration services, regardless of the type of compensation or fees that they receive; and
  • Service providers who receive indirect compensation in connection with accounting, actuarial, auditing, legal, or valuation services.

The proposed regulations only apply to contracts or arrangements for services to employee benefit plans. Prop. Reg. § 2550.408b-2(c)(1)(i). The rules would not apply to contracts or arrangements with entities merely providing benefits to participants and beneficiaries, rather than providing services to the plan itself. An example provided in the preamble describes a contract with a medical provider network and concludes that the doctor who is part of the network would not be a service provider to the plan because the doctor merely provides medical benefits to the plan’s participants and beneficiaries.

Disclosure of Services and Compensation

The proposed regulations require that the contract or arrangement be in writing (Prop. Reg. § 2550.408b-2(c)(1)(ii)) and include the following:

  • The requirement that the service provider disclose in advance and in writing the information described in the proposed regulations (Prop. Reg. § 2550.408b-2(c)(1)(iii));
  • A representation by the service provider that, before the contract or arrangement was entered into (or extended or renewed), all required information was provided to the fiduciary (Prop. Reg. § 2550.408b-2(c)(1)(iii));
  • A description of all services to be provided to the plan pursuant to the contract (even if the services are outside the categories subject to the new disclosures as described in Prop. Reg. § 2550.408b-2(c)(1)(i)) (Prop. Reg. § 2550.408b-2(c)(1)(iii)(A)); and
  • The compensation or fees to be received by the service provider with respect to each service it will provide, and the manner of receipt of such compensation or fees (Prop. Reg. § 2550.408b-2(c)(1)(iii)(A)).

“Compensation or fees” are broadly defined to include money or any other thing of monetary value 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 affiliates in connection with the services to be provided pursuant the contract. Prop. Reg. § 2550.408b-2(c)(1)(iii)(A)(1). Examples of compensation and fees that must be disclosed (as described in the preamble) include gifts, awards, trips for employees, research, finder’s fees, placement fees, commissions or other fees related to investment products, sub-transfer agency fees, shareholder servicing fees, Rule 12b-1 fees, soft dollar payments, float income, fees deducted from investment returns, fees based on a share of gains or appreciation of plan assets, and fees based upon a percentage of the plan’s assets. The DOL also notes that while an investment of plan assets or the purchase of insurance is not, in and of itself, compensation to a service provider, persons or entities that provide investment management, recordkeeping, participant communication and other services to the plan as a result of an investment of plan assets will be treated as providing services to the plan.

The proposed rules indicate that 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. However, the compensation and fee information must be provided in a manner and with sufficient information to allow the plan fiduciary to evaluate the reasonableness of the compensation or fees. Prop. Reg. § 2550.408b-2(c)(1)(iii)(A)(2).

In the case of bundled services, 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, as a general matter, only the service provider offering the bundle must provide the required disclosures for all the services and aggregate compensation and fees to be received by all the parties in connection with the bundle of services. In such case, no allocation of compensation or fees among the service provider, its affiliates, subcontractors or other third-parties is required, except to the extent the party receives or may receive compensation or fees that are a separate charge directly against the plan’s investments, reflected in the net value of the investments, or 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). Prop. Reg. § 2550.408b-2(c)(1)(iii)(A)(3).

As part of the description of the manner of receipt of compensation or fees, the service provider must state whether it 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. Prop. Reg. § 2550.408b-2(c)(1)(iii)(A)(4).

The proposed regulations do not prescribe the manner or form in which such disclosures should be provided to the plan fiduciary. As noted in the preamble, all the required disclosures need not be contained in the same document and may be provided in electronic format. The proposed regulations also do not designate any specific time period prior to entering into the contract or arrangement for the receipt of the required disclosures, other than requiring that it is provided before the parties enter into the contract. However, the DOL expects the service provider to furnish current and accurate information to the plan fiduciary and that the plan fiduciary must ensure receipt of the information sufficiently in advance of entering into the contract to prudently consider the information.

Disclosure of Conflicts of Interest

In addition to the service and fee disclosures, the written contract must include the following disclosures to help plan fiduciaries understand the relationships and indirect sources of compensation that may create potential conflicts of interest:

  • Whether the service provider (or an affiliate) is a fiduciary either under ERISA or the Investment Advisers Act of 1940 (Prop. Reg. § 2550.408b-2(c)(1)(iii)(B));
  • Whether the service provider 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, which transaction is to be explained along with the service provider’s interest in it (Prop. Reg. § 2550.408b-2(c)(1)(iii)(C));
  • Whether the service provider 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 crate a conflict of interest for the service provider (Prop. Reg. § 2550.408b-2(c)(1)(iii)(D));
  • Whether the service provider will be able to affect its own compensation or fees without the prior approval of an independent plan fiduciary (Prop. Reg. § 2550.408b-2(c)(1)(iii)(E)); and
  • Whether the service provider has any policies or procedures that address actual or potential conflicts of interest (Prop. Reg. § 2550.408b-2(c)(1)(iii)(F)).

Ongoing Disclosure and Enforcement

Finally, the proposed regulations require the contract to include the following ongoing disclosure obligations:

  • The service provider must disclose any material change to the required disclosures within 30 days (Prop. Reg. § 2550.408b-2(c)(1)(iv)); and
  • The service provider must disclose all information requested by the plan fiduciary or administrator in order to comply with the reporting requirements of ERISA (e.g., Form 5500 and Schedule C) (Prop. Reg. § 2550.408b-2(c)(1)(v)).

With regard to enforcement, the proposed regulations include the following:

  • The service provider must actually comply with its disclosure obligations under the contract ((Prop. Reg. § 2550.408b-2(c)(1)(vi)); and
  • As is the standard under the existing regulations, the contract must permit termination by the plan on reasonably short notice if the arrangement becomes disadvantageous to the plan (Prop. Reg. § 2550.408b-2(c)(2)).

If a contract fails to require disclosure of the information described in the proposed regulations, or if a service provider fails to disclose such information, then the contract will not be “reasonable.” Therefore, the service arrangement will not qualify for relief from ERISA’s prohibited transaction rules in Section 408(b)(2). In such circumstances, in the case of a retirement plan, the service provider will be subject to excise taxes that result from the service provider’s participation in a prohibited transaction under Internal Revenue Code Section 4975. In the case of a welfare plan that is not covered by Code Section 4975, the service provider may have exposure to civil penalties under ERISA Section 502(i).

Proposed Class Exemption

The proposed class exemption that the DOL published in conjunction with the proposed fee disclosure regulations would provide relief from the prohibited transaction rules for a plan fiduciary when, unbeknownst to the fiduciary, a service provider fails to comply with the disclosure requirements. When entering into the contract, the responsible plan fiduciary must have reasonably believed that the contract met the requirements of the proposed fee disclosure regulations. Section II.A. In addition, the plan fiduciary must not have known, or had reason to have known, that the service provider failed, or would fail, to comply with its disclosure obligations. Id. Upon discovery that the service provider failed to comply with its disclosure obligations, the plan fiduciary must request in writing that the service provider furnish the information. Section II.B.1. If the service provider fails to comply within 90 days, the plan fiduciary must notify the DOL not later than 30 days following the earlier of (i) the service provider’s refusal to furnish the requested information, or (ii) the expiration of the 90 days. Section II.B.2 (the timing, content, and other notice requirements are detailed in Section III). Finally, after the plan fiduciary discovers that the service provider failed to comply with its disclosure obligations, the proposal requires the fiduciary to determine whether to terminate or continue the contract or arrangement. Section II.C. It should be noted that even if the delinquent service provider furnishes information timely in response to the fiduciary’s request, the plan administrator may still have the obligation to report the occurrence of a prohibited transaction in accordance with the instructions to Form 5500.

Submitting Comments

Service providers and plan sponsors are encouraged to submit comments on the proposals to the DOL. Comments are due by February 11, 2008. The DOL has specifically requested comments on a number of issues, including the following:

  • Whether and the extent to which duplicate disclosures can be avoided while at the same time ensuring that responsible plan fiduciaries receive comprehensive, straightforward, and helpful information concerning the service provider’s compensation and possible conflicts of interest;
  • Any practical issues relating to the current regulation’s requirements concerning contract termination. Specifically the DOL would like to know whether the current regulatory framework presents practical problems and whether further regulatory or interpretive guidance could address these problems;
  • The extent to which the application of the disclosure requirements contained in the proposed regulations will affect, or may be affected by, other ERISA statutory exemptions that may relate to plan service arrangements; and
  • The question whether the final regulations should be made effective on a different date.

Significance of the Proposals

Due to the focus on 401(k) fee issues by the DOL, Congress, and the courts, retirement plan service providers have been anticipating this new guidance perhaps more than health plan service providers. In fact, some health plans may be surprised to learn the extent to which they will be affected by these rules. The scope of the proposed rules clearly applies to health and welfare plans, many of which commonly operate under business arrangements where indirect fees will now need captured and reported. Service providers to those types of plans will need to closely examine the compliance issues and develop a strategy to address the new disclosures.

The proposed regulations are likely to create a significant shift in the contracting process between pension and welfare plans and their service providers. Most of the compliance efforts, and the resulting costs, will initially fall to the service providers. However, these costs are likely to be passed to the plans or employer-sponsors in the form of increased administrative fees.

While service providers will collect much of this information in order to provide it to the plan sponsor/ fiduciary for the revised Schedule C of Form 5500, because information needs to be provided prospectively under the proposed regulations and retrospectively (after the end of the plan year) for the Form 5500, service providers may realize only limited efficiency. Furthermore, some of the information, such as a detailed description of services and conflicts of interests, is newly required with this set of proposed regulations.

Although the proposed regulations focus on service provider disclosures, plan fiduciaries are not off the hook. The proposed regulations only require service providers to disclose (currently, in a non-comprehensive manner) fee-related information. Once that information is made available, the focus will be on whether the plan fiduciaries have actually read, understood, and made prudent decisions in light of that information. Litigation, such as the recent class actions involving plan-related fees, will continue to be directed at the plan fiduciaries, who should not rely on contractual remedies to recover from the service provider.

In addition to any costs that may be passed on from the service provider, plan sponsors/fiduciaries are likely to experience additional costs in terms of the time it will take to ensure the service providers disclosed all required information and then to perform a thorough analysis in order to determine whether the compensation and fees are reasonable. While both employers and service providers have been generally supportive of the DOL’s fee disclosure initiatives, it’s still uncertain how much value will be gained.

For further information, please contact any of the following lawyers:

Susan Relland

Elizabeth Drake, edrake@milchev.com, 202-626-5838

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