Overview of Final DOL Regulation under ERISA 408(b)(2)

Under ERISA section 406(a)(1)(C), there is a general prohibition on the furnishing of goods, services, or facilities between a plan and a party in interest to the plan. As a result, a service relationship between a plan and a service provider would constitute 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, section 408(b)(2) of ERISA exempts certain arrangements between plans and service providers that otherwise would be prohibited transactions under section 406 of ERISA. Specifically, section 408(b)(2) provides relief from ERISA’s 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. In regards to the reasonableness of the contract or arrangement, the exemption merely states "[it] is not reasonable unless it permits the plan to terminate without penalty on reasonably short notice."

Thus, while plan fiduciaries are obligated to obtain information about fees and conflicts of interests, the current ERISA section 408(b)(2) lacks more specific guidelines for how and to what extent that information is to be provided. Further, under the current provisions, it is unclear as to whether or not service providers who are not ERISA fiduciaries are obligated to provide the information that the DOL believes plan fiduciaries need in order to evaluate whether a provider’s fees are reasonable. The DOL found this ambiguity to be problematic and believed that by amending ERISA section 408(b)(2), "plan fiduciaries would benefit from a clear and uniform regulatory standard for disclosure."

On July 15, 2010, the DOL issued its final regulation requiring covered service providers to satisfy certain disclosure requirements in order to qualify for the statutory exemption for services under ERISA section 408(b)(2). Specifically, it establishes a requirement that, in order for certain contracts or arrangements for services to be reasonable, the covered service provider must disclose specified information to a responsible plan fiduciary, defined as a fiduciary with authority to cause the plan to enter into, or extend or renew, a contract or arrangement for the provision of services to the plan. A "covered service provider" is a service provider that enters into a contract or arrangement with the covered plan and reasonably expects to receive $1,000 or more in compensation, direct or indirect, to be received in connection with providing one or more specified services.

The first category of covered service providers includes those providing services as an ERISA fiduciary or as an investment adviser registered under either the Investment Advisers Act of 1940 (Advisers Act) or any State law. The second category includes providers of recordkeeping services or brokerage services, and the third includes those providing specified services when they expect to receive "indirect" compensation or certain payments from related parties. The services included in this category are accounting, auditing, actuarial, appraisal, banking, consulting (i.e., consulting related to the development or implementation of investment policies or objectives, or the selection or monitoring of service providers or plan investments), custodial, insurance, investment advisory (for plan or participants), legal, recordkeeping, securities or other investment brokerage, third party administration, or valuation services provided to the covered plan.

The final regulation requires covered service providers to disclose the following information to a responsible plan fiduciary, reasonably in advance of the date the contract or arrangement is entered into (and extended or renewed), in writing –

· Services. A description of the services to be provided pursuant to the contract or arrangement;

· Status. If applicable, a statement that the provider, an affiliate, or a subcontractor will provide, or reasonably expects to provide, services as a fiduciary and/or an investment adviser registered under the Advisers Act or any State law;

· Compensation. A description of all direct and indirect (i.e., commissions, 12b-1 fees for designated investment alternatives, etc.) compensation received by the provider, an affiliate, or a subcontractor in connection with the services – the disclosure of indirect compensation must identify the services for which such compensation will be paid and the payers and recipients of such compensation (including the status of a payer or recipient as an affiliate or a subcontractor); and

· Compensation for Termination. A description of any compensation that the provider, an affiliate, or a subcontractor reasonably expects to receive in connection with termination of the contract or arrangement, and how any prepaid amounts will be calculated and refunded upon such termination.

Any changes to this information must be disclosed by the provider as soon as practicable, but not later than 60 days from the date on which the provider is informed of such change. Any additional information requested by the plan fiduciary related to compensation received by the provider, which is necessary for the plan fiduciary to comply with reporting requirements under Title I of ERISA, must be disclosed no later than 30 days following the receipt of a written request. A description or an estimate of compensation may be expressed as a monetary amount, formula, percentage of plan assets, or a per capita charge for each participant or beneficiary or, if the compensation cannot reasonably be expressed in such terms, by any other reasonable method. Lastly, the final regulation provides for a safe harbor for plan fiduciaries when a covered provider fails to disclose the required information provided, however, that the plan report certain information about that provider to the DOL.

The disclosures must be delivered by July 16, 2011, regardless of whether the contract or arrangement was entered into prior to such date. The impact of this regulation could be substantial for many firms, as non-compliance with the disclosure and delivery requirements will result in the arrangement being a prohibited transaction and can lead to disgorgement, excise taxes, personal liability, etc.

The final regulation is expected to disproportionately affect broker-dealers. Given that RRs, as well as their firms, receive ongoing, indirect compensation from investment providers in the form of un-level 12(b)(1) fees, for example, broker-dealers whose RRs are determined to be providing investment advice will be at risk for potential prohibited transactions if that compensation is disclosed in writing. Although the burden is on the plaintiff to prove that the RRs are providing fiduciary investment advice, firms should implement appropriate safeguards to monitor this activity at the plan and participant level.

Additionally, many plan sponsors will be surprised to learn of the nature and extent of the compensation paid to their adviser out of the expenses charged against their participants’ investments. Plan sponsors that may have thought they were, or in fact actually were, receiving investment advice from their RRs will likely require the RR to explain his/her value proposition in light of the perceived or actual reduction in services. Firms should begin implementing strategies to assist their advisers in preparing a response to the above-referenced issues and, in demonstrating their value, to justify the receipt of ongoing compensation paid out of plan assets.