New Regulations Under ERISA Section 408(b)(2) Require Additional Disclosure of Service Provider Compensation

On July 16, 2010, the United States Department of Labor (DOL) published interim final regulations[1] under Section 408(b)(2) of the Employee Retirement Income Security Act of 1974, as amended (ERISA).  The stated purpose of these regulations is to require that certain service providers to employee benefit plans subject to ERISA (“Plans”) disclose information to Plan fiduciaries such that the fiduciaries may determine the “reasonableness” of contracts or arrangements that they enter into(including the reasonableness of the service providers’ compensation) and the conflicts of interest that may affect the service providers’ performance of services to Plans. 

Background

Unlike the recent rule changes relating to Schedule C of the IRS Form 5500 (the annual tax return of a tax-qualified employee benefit plan), which require detailed reporting regarding service provider compensation, these regulations place the onus squarely on the Plan and the service provider, in that failure to comply with their requirements could nullify the benefit of Section 408(b)(2) of ERISA that certain service providers must rely upon in order to receive compensation for services to a Plan (e.g., performance and management fees).

ERISA can classify virtually every transaction in which a Plan may engage, routine or otherwise, as a prohibited transaction.  In order to allow Plans to engage in routine transactions, ERISA establishes certain statutory exemptions to the prohibited transaction rules, and further exemptions have been established by the DOL.

Section 408(b)(2) of ERISA provides a statutory exemption from the party-in-interest prohibitions for any “reasonable” contract or arrangement with a party-in-interest, including a fiduciary, for any office space or legal, accounting or other services (including investment management services) “necessary” for the establishment or operation of a Plan, if no more than “reasonable compensation” is paid therefor.  ERISA also clarifies that the prohibited transaction rules do not prohibit a fiduciary from receiving compensation for services rendered or for the reimbursement of expenses properly and actually incurred in the performance of its duties with respect to the Plan.

Currently,  the regulations under Section 408(b)(2) provide only that a contract or arrangement involving a Plan will not be “reasonable” unless it permits the Plan to terminate the contract or arrangement without penalty on reasonably short notice.  The new regulations adds a requirement that, in order for a contract or arrangement to be considered “reasonable,” a “covered service provider” providing services to a “covered Plan” must disclose specified information to the Plan fiduciary having authority to cause the Plan to enter into, extend or renew the contract or arrangement.

These new regulations are generally effective on July 16, 2011.  Set forth below is a summary of these regulations and the potential impact they will have on certain service providers to Plans.

Covered Plans

Currently, the regulations generally provide that the new disclosure requirements apply only to those pension or retirement plans subject to ERISA (so, for example, an individual retirement account is not considered to be a “covered Plan”). However, the DOL has reserved a section in the regulations for future guidance with respect to welfare plans.

Covered Service Providers

The regulations provide that covered service providers include those service providers that enter into a contract or arrangement with a covered Plan reasonably expecting to receive, directly or indirectly, $1,000 or more in compensation for performing the following services—

• services provided directly to the covered Plan as a fiduciary
• services provided as a fiduciary to an investment contract, product or entity (such as a commingled investment fund) that holds Plan assets and in which the covered Plan has a direct equity investment (therefore, unlike the recent changes to the Form 5500, this provision of the regulations does not apply to “under 25% funds”)
• services provided directly to the covered Plan as an investment adviser registered under the Investment Advisers Act of 1940 or any state law
• recordkeeping services or brokerage services provided to a covered Plan that is an individual account plan and that permits participants or beneficiaries to direct investment of their accounts among investment alternatives (e.g., many 401(k) and profit-sharing plans) if one or more designated investment alternatives are made available (e.g., through a platform or other mechanism) in connection with such recordkeeping or brokerage services
• accounting, auditing, actuarial, appraisal, banking, certain consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities or other investment brokerage, third-party administration or valuation services provided to a covered Plan for which the service provider, affiliate or subcontractor reasonably expects to receive indirect compensation.  No person or entity will, however, be considered a “covered service provider” solely by reason of providing services other than as a fiduciary to an entity in which a covered Plan invests, whether or not such entity is considered to hold Plan assets.

Required Disclosure

The regulations require covered service providers to disclose the following in writing to responsible Plan fiduciaries (for purposes of the regulations, a “responsible Plan fiduciary” is a fiduciary with the authority to cause a covered Plan to enter into, or extend or renew, a contract or arrangement for the provision of services with a covered service provider)—

• a description of the services to be provided
• if applicable, a statement that the covered service provider is providing services directly to the covered Plan as a fiduciary or as an investment adviser
• a description of all direct and indirect compensation reasonably expected to be received by the covered service provider, an affiliate or a subcontractor, in connection with the provision of services to the covered Plan (including commissions, soft dollars, finder’s fees, 12b-1 fees and similar compensation based on business placed or retained), including, in the case of indirect compensation, the identity of the payor of the compensation
• a description of any compensation reasonably expected to be received by the covered service provider in connection with termination of the contract or arrangement, including how any prepaid amounts will be calculated and refunded upon such a termination
• if recordkeeping services are to be performed, a description of all direct and indirect compensation expected to be received in connection with such services and reasonable estimates of the costs of such services in instances where no explicit compensation is paid therefor (such as, for example, when the recordkeeping services are provided in connection bundled service arrangements)
• a description of the manner in which compensation will be received, such as whether the covered Plan will be billed or the compensation deducted directly from the covered Plan’s accounts or investments.

In the event that services are provided as a fiduciary to an investment contract, product or entity that holds Plan assets and in which the covered Plan has a direct equity investment and such information is not disclosed to the Plan by a covered service provider providing recordkeeping services or brokerage services to the covered Plan, the fiduciary must also provide—

• a description of any compensation that will be charged directly against the amount invested in connection with the acquisition, sale or transfer of, or withdrawal from, the investment contract, product or entity (e.g., sales loads, sales charges, deferred sales charges, redemption fees, surrender charges, exchange fees, account fees and purchase fees)
• a description of the annual operating expenses (e.g., expense ratio) if the return is not fixed
• a description of any ongoing expenses in addition to annual operating expenses (e.g., wrap fees, mortality and expense fees).

Timing

The disclosure must be made reasonably in advance of the date the contract or arrangement is entered into, extended or renewed. In the event of changes, the change must be disclosed as soon as practicable, but not later than 60 days after the date on which the covered service provider is informed of such change, unless such disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control, in which case the information must be disclosed as soon as subsequently practicable.  In the event that an investment contract, product or entity not holding Plan assets is subsequently determined to hold Plan assets, the required information must be disclosed as soon as practicable, but not later than 30 days after the date on which the covered service provider knows that such contract, product or entity holds Plan assets.

In addition, upon request by a covered Plan, the covered service provider must furnish any other information relating to services rendered to the covered Plan that is required for the covered Plan to comply with the reporting and disclosure requirements of Title I of ERISA, e.g., the annual Form 5500.

Errors and Omissions

The interim final regulations provide that a contract or arrangement will not fail to be reasonable if the covered service provider makes an error or omission in the required disclosure if the covered service provider (i) was acting in good faith and with reasonable diligence and (ii) discloses the correct information to the responsible plan fiduciary as soon as practicable, but not later than 30 days after the date on which the covered service provider knows of such error or omission.

Recommended Actions

As noted above, the regulations generally become effective on July 16, 2011.  The regulations provide that their requirements will apply to all contracts or arrangements between covered Plans and covered service providers on the effective date, whether or not entered into prior to the effective date.  Any information required to be provided pursuant to the regulations in respect of contracts or arrangements entered into prior to the effective date must be furnished no later than the effective date.  Because of this, investment managers and advisors, as well as other direct or indirect providers of financial services to Plans or entities in which they invest should consider whether their current contracts or arrangements, or those anticipated to be entered into before July 16, 2011, are or will be subject to the regulations.  For those contracts or arrangements expected to be entered into prior to the effective date, it may be advisable to provide any required disclosure at the time the contract or arrangement is entered into, rather than waiting until the effective date.

In anticipation of the effectiveness of the regulations, financial service providers should consider the following—

1.  Are we a “covered service provider”?

To determine the applicability of the regulations to its operations, a financial service provider should first determine if it provides the types of services covered by the regulations.  As noted above, these include acting as a fiduciary (e.g., an investment manager) or a registered investment advisor or providing recordkeeping, brokerage, accounting, auditing, actuarial, appraisal, banking, certain consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities or other investment brokerage, third-party administration or valuation services, in each case for which the service provider expects to receive at least $1,000.  If an entity is, or will be, providing any of these services, it should then determine if it is, or will be, providing such services to a covered Plan.

2.  Do we provide services to a “covered Plan”?

A service provider will be subject to the regulations if it is providing any of the services described under Question 1 (above) directly to a covered Plan.  As a general matter, any private, U.S. pension or retirement Plan should be considered a covered Plan for purposes of the regulations unless determined otherwise.  In addition, a fiduciary (e.g., an investment manager or, in many cases, an investment advisor) to an investment contract, product or entity holding Plan assets will also be subject to the regulations.

In anticipation of the effectiveness of the regulations, service providers may wish to review those entities to which they provide services to determine if any of their clients are either (i) U.S. pension or retirement Plans or (ii) Plan asset entities.  If any uncertainty exists, the service provider should consider asking its clients for a representation regarding their status as a “covered Plan” for purposes of the regulations.  For contracts or arrangements not yet entered into, such a representation could be included in the documents governing the relationship.

3.  Is the exemptive relief of ERISA Section 408(b)(2) necessary for the services we provide?

As noted above, Section 408(b)(2) of ERISA provides a statutory exemption from the party-in-interest prohibitions of ERISA for any “reasonable” contract or arrangement with a party-in-interest if its conditions are met.  In general, unless another exemption were available, the payment of fees by a Plan asset fund to an investment manager would be a prohibited transaction under ERISA unless Section 408(b)(2) provided exemptive relief.  There are, however, other exemptions from the prohibited transaction provisions of ERISA that may apply to such contracts or arrangements.  For example, Prohibited Transaction Class Exemption 84-14 (the “QPAM Exemption,” covering transactions entered into through a qualified professional asset manager) could provide exemptive relief for such contracts or arrangements.  If the QPAM Exemption is available, a service provider being retained to provide services directly to a Plan or to a Plan asset entity should consider requesting a representation that the QPAM Exemption will be available throughout the period that a contract or arrangement with a covered Plan is outstanding.

4.  How must the required information be provided?

If a covered service provider is providing services to a covered Plan under a contract or arrangement for which the exemptive relief of ERISA Section 408(b)(2) is needed, the service provider must ensure that the necessary disclosures are provided in writing to the responsible Plan fiduciary.  The documentation regarding the relationship should be reviewed to determine if the required disclosure is contained therein.  For example, an investment management agreement may include all of the disclosure required by the regulations.  If not, supplemental disclosure should be provided.

[1] 75 Fed. Reg. 41600 (July 16, 2010)

Michael Roebuck

mroebuck@akingump.com 212.872.8102
New York