By: Stephen P. Wilkes, Partner; Mark Greenstein, Of Counsel
DOL PROPOSES TOUGHER PROHIBITED TRANSACTION EXEMPTION PROCEDURES
LAW
The Employee Retirement Income Security Act of 1974, as amended (“ERISA”), was enacted in part to protect the retirement savings of participants in their employers’ retirement plans and IRA owners and beneficiaries in their IRAs from losses due to transactions with persons with specified relationships to the plan. This includes broad prohibitions against self-dealing by fiduciaries and specified transactions with “parties in interest” defined in ERISA and “disqualified persons” under the Internal Revenue Code of 1986 (the “Code”). As a consequence, ERISA prohibits certain self-dealing and other potentially abusive transactions (“prohibited transactions”) by fiduciaries and parties in interest with respect to employee benefit plans and IRAs. Parallel provisions of the Code impose excise tax penalties for engaging in prohibited transactions.
However, because of the breadth of these rules, Congress provided for three kinds of possible exemptions from the prohibited transaction prohibitions: statutory exemptions, class exemptions and individual exemptions (granted to individual applicants). The Department of Labor (“DOL”) has long had regulations setting forth the procedures for applying for class and private exemptions and has granted many such exemptions over the last 48 years. Now, however, the DOL is proposing changes to its procedures that would significantly modify the process and create additional burdens on applicants and independent fiduciaries covered by the exemption.
BACKGROUND
On March 15, 2022, the DOL published proposed amendments to its regulations specifying the procedures for applying for class and individual exemptions and the processing of such applications. If finalized as recently proposed, these changes would impose significant new requirements on applicants and other actors (such as appraisers and independent fiduciaries) who are involved in transactions that require an exemption.
Comments to the DOL were originally due by April 14, 2022, but the time has been extended to May 29, 2022. If adopted, the amendments will apply prospectively (excluding exemption applications already submitted) 90 days following publication of the adoption of the amendments in the Federal Register.
Pursuant to Section 408 of ERISA, Code section 4975(c)(2) and the DOL’s existing regulations governing the granting of exemptions, three conditions must be met: the DOL must determine that the exemption is (1) administratively feasible, (2) in the interests of participants and beneficiaries, and (3) protective of the rights of participants and beneficiaries. These regulations further require applicants to (1) submit detailed information to the DOL (and update it as required to keep it materially accurate) and (2) notify those who may be affected by the exemption so as to allow them to comment on a proposed exemption, and the regulations provide that documents submitted to the DOL in connection with an exemption request will be available to the public upon request.
Over the past two decades, the DOL has reduced its rate of granting exemptions from dozens per year to just three in 2021 and the exemption process has taken longer, become more complicated and become more costly. The number of applications for exemptions, however, is not known to have decreased proportionately. The proposed amendments do not appear likely to improve these trends, or ultimately to enable plans and participants to benefit from prudently issued exemptions. In fact, they may force applicants to choose less beneficial transactions or avoid the transactions altogether, a lost opportunity for the plan and its participants.
SUMMARY OF PROPOSED AMENDMENTS
The proposed amendments to the exemption application regulations include some of the DOL’s existing policy positions that are already being applied to exemption requests and would also add a number of significant new requirements. These are summarized below.
I. Before Submission
Under the proposed amendments, all communications with the DOL regarding a requested exemption will become part of the administrative record that the public can obtain on request. They also prohibit asking the DOL on an anonymous basis about specific factual patterns, even if the purpose of the discussion is not with respect to a potential exemption but to seek confirmation that an exemption is not needed.
These changes would preempt the common practice of seeking a meeting with the DOL’s exemption staff to discuss what the staff’s attitude would be toward a requested exemption before a would-be applicant incurs the time and expense of preparing a formal application. They may prevent plan sponsors and service providers from consulting the DOL to request informal views that they do not need to request an exemption because, for example, under their facts no prohibited transaction would occur or because another exemption is available.
II. Impartial Conduct Standards
The proposed amendments provide that the DOL will presume that the impartial conduct standards of the DOL’s fiduciary advice class exemption (PTE 2020-02) will be applied to each new exemption. The impartial conduct standards are:
- The transaction is in the “best interest” of the plan and its participants and beneficiaries, meaning the fiduciary causing the plan to enter into the transaction determines, with the care, skill, prudence, and diligence under the circumstances then prevailing, that a prudent person acting in a like capacity and familiar with such matters would, in the conduct of an enterprise of a like character and with like aims, enter into the transaction based on the circumstances and needs of the plan, and that such fiduciary shall not place the financial or other interests of itself, a party to the transaction, or any affiliate ahead of the interests of the plan, or subordinate the plan’s interests to any party or affiliate;
- All compensation received, directly or indirectly, by a party involved in the transaction does not exceed reasonable compensation; and
- All of the statements to the DOL, the plan, or, if applicable, the independent fiduciary or appraiser about the transaction and other relevant matters are not, at the time the statements are made, materially misleading.
Observation: An exemption applicant who could not (or did not wish to) meet these impartial conduct standards would bear the burden of establishing why the standards should not apply to its requested exemption. This would be a significant expansion of the DOL’s policy regarding impartiality.
Since these rules also apply to exemptions for IRA transactions, it would create a fiduciary standard for exemptions covering IRAs that are otherwise not subject to ERISA’s fiduciary standard of care. This could be argued to be inconsistent with the reasoning of the Fifth Circuit’s decision to vacate the DOL fiduciary regulations.
III. Independent Fiduciaries and Appraisers
Exemptions often impose requirements that an independent fiduciary with no conflict of interest involving the transaction be appointed to represent the interests of the plan and, if relevant, an independent appraiser to establish that the plan will pay no more for or receive no less than the fair market value of an asset in a transaction. The proposed amendments would impose new requirements for independent fiduciaries and appraisers, including:
- When a fiduciary or appraiser will be considered “independent.”
- The current regulations include a percentage of revenue test: a fiduciary or appraiser is
- deemed independent if less than 2% of its revenue is derived from parties involved in the transaction but
- based on the facts and circumstances, the fiduciary or appraiser may nonetheless be independent if the revenue is less than 5%.
- The amendments would
- Make the 2% of revenue limit the sole standard (subject to the DOL’s sole discretion to determine otherwise), and
- would require the calculation to incorporate both the fiduciary’s or appraiser’s total revenue from the prior tax year and a projection of total revenue in the current year.
Observation: The new 2% of revenue standard of independence will be harder for exemption applicants to meet and could reduce competition, by narrowing down the field of smaller firms. It could impact smaller entities by limiting the amount of work they do for any one client and allow a larger entity to negotiate a larger fee by virtue of its overall revenue characteristics. Will this affect what is considered reasonable compensation if fees increase due to reduced competition? Why reduce competition by providing for a different standard for exemption purposes than what the DOL has previously allowed as appropriate for determining when a party may be considered independent of another entity: if less than 5% of its revenue is derived from the other entity. See, e.g., DOL Adv. Op. 2001-09 (Dec. 14, 2001).
- The proposed amendments impose a new requirement that an appraiser must also be independent of the independent fiduciary, not merely the applicant.
- The amendments also state that an entity may not be considered independent if it has an interest in the subject transaction or future transactions of the same nature or type.
Observation: In the preamble to the proposed amendments, the DOL stated that it is concerned that certain independent fiduciaries may have a “business interest” in facilitating an exemption transaction, such as to promote its independent fiduciary services to other clients, or to promote a relationship with a third party, such as an investment advisor or bank. The uncertainly inherent in this standard will likely reduce the number of entities willing to serve as independent fiduciaries, reduce competition and increase fees.
- The amendments would set certain standards for a plan’s contract with an independent fiduciary or appraiser:
- The contract could not include indemnification for breach of contract or violations of applicable law, or a waiver of the plan’s claims under applicable law, including ERISA.
Observation: This provision would formalize the DOL’s current informal approach for prohibited transaction exemptions. Instead, the Department should consider a more flexible approach such as requiring that the arrangement be commercially reasonable considering available alternatives.
- An independent fiduciary would be required to maintain fiduciary liability insurance in an amount that is sufficient to indemnify the plan for damages resulting from a breach by the independent fiduciary of either (a) ERISA, the Code, or any other federal or state law, or (b) its agreement with the plan. The insurance may not contain an exclusion for actions brought by the DOL or any other federal or state regulator, the plan, or plan participants or beneficiaries.
Observation: For very large transactions, this may make fiduciary insurance unavailable or at least prohibitively expensive. The cost of such insurance would presumably include a profit margin and a margin for asymmetric information which will be borne, at least in part, by plans by making the terms less favorable. The only positive could be a screening or oversight function that would make claims less likely. As the Department notes, many and perhaps most independent fiduciaries have an interest in future business and can more accurately assess risk as they have more complete information. This interest appears to duplicate the only positive from insurance since any claim resulting in a payout would materially damage the ability to obtain future business. Therefore, the expense of insurance would represent a cost with no commensurate benefit in most cases.
- An independent appraiser would need to certify under penalty of perjury that, to the best of its knowledge, all of the representations made in its appraisal report are true and correct.
- Compared to the current exemption procedures regulations, the amendments would require the provision of more information regarding independent fiduciaries and appraisers in the application, including:
- A description of the diligence process leading to the selection of the independent fiduciary or appraiser, including the number of candidates reviewed and references contacted;
- With respect to independent appraisers, a description of any past engagements the plan or any party involved with the exemption transaction has had with the appraiser; and
- With respect to independent fiduciaries, (a) either (i) a statement that, within the last five years, the independent fiduciary has not been under any regulatory investigation, examination, or litigation, or (ii) a description of such regulatory investigation, examination, or litigation; and (b) either (i) a statement that, within the last 13 years, the independent fiduciary has not been either convicted or released from imprisonment for certain felonies, including under foreign law, or (ii) a description of such conviction and the circumstances that led to such conviction.
- Finally, the proposed amendments would also provide the DOL with the right to a conference with the independent fiduciary or appraiser without the participation of the exemption applicant.
Observation: This conference right of the DOL is only a formalization of the DOL’s current practice.
IV. Information to Be Included in Applications
The proposed amendments would require even more information from the applicant than the voluminous amount already required, including:
- A description of material benefits non-plan parties would receive as a result of the transactions the exemption would permit.
- The costs and benefits (quantified if possible) of the transaction to plans, participants, and beneficiaries.
- A detailed description of potential alternatives to engaging in the prohibited transaction (if an exemption is granted), and why those alternatives were not pursued.
- A description of each conflict of interest or potential instance of self-dealing that would be permitted if the exemption is granted.
- With respect to applications for individual exemptions, the applicant would need to report:
- foreign (in addition to domestic) criminal convictions and
- any prior transaction between (i) the plan or plan sponsor and (ii) a party involved in the transaction.
Observation: The cost of this requirement would eliminate transactions that would otherwise be commercially favorable for plans, and consequently reduce plan investment returns. Further, many applicants would not have the resources to perform or pay for a cost/benefit analysis that is similar to what would be required of a federal agency’s regulatory impact analysis.
The DOL explained in the preamble to the proposed amendments that the requirement to report prior transactions is intended to allow the DOL to determine whether the proposed transaction fits into a larger pattern or practice.
V. Ongoing Reporting to DOL until Grant of Exemption
In addition to the current requirement to update the DOL if any material fact or representation in the application changes or becomes inaccurate prior to final action of the DOL, the proposed amendments provide that if, at any time during the pendency of an exemption application, the applicant or any other party participating in the transaction becomes the subject of an investigation or enforcement action by the DOL, the Internal Revenue Service (“IRS”), the Justice Department, the Pension Benefit Guaranty Corporation, the Federal Retirement Thrift Investment Board, or any other federal or state governmental entity involving compliance with provisions of ERISA, provisions of the Code relating to employee benefit plans, or provisions of Federal Employees’ Retirement System Act of 1986 (“FERSA”) relating to the Federal Thrift Savings Fund, the applicant must promptly notify the DOL.
VI. Other Changes
The proposed amendments would:
- Formalize the DOL’s current position that an applicant is not entitled to an exemption solely because the DOL has granted the same or a substantially similar exemption in the past.
- Prohibit the costs of notifying interested persons of the exemption, as well as commissions, fees, or costs associated with the exemption transaction, from being charged to plan assets, unless there are compelling circumstances necessitating otherwise.
- Impose requirements with respect to a “party involved in the exemption,”
- including that the independent fiduciary and appraiser must be independent from such parties, and
- that information regarding the relationship between such parties and the independent fiduciary and appraiser, the plan, and the applicant and its affiliates must be reported to DOL. (“Parties involved in the transaction” include service providers and their affiliates.)
- Enhance the DOL’s right to deny an exemption application before providing the applicant with an opportunity for a conference with the DOL and respond to issues identified by the DOL.
- Require a statement that every proposed exemption either will be in the best interest of the plan and its participants and beneficiaries or a statement as to why this standard should not be applicable to the exemption transaction.
- Require a higher level of scrutiny for retroactive exemption applications.
- Make substantive revisions to several existing definitions and add new definitions, such as affiliate, control, independent fiduciary and qualified independent appraiser, which now includes a review of the appraiser’s and fiduciary’s projected revenues relating to the proposed exemption.
- State that the DOL will generally not consider any applications if the transaction or a party in interest is being investigated under any federal or state laws.
- Warn that any information provided by the applicant cannot be deemed confidential and would be made available to the public.
ADDITIONAL CONSIDERATIONS
Although many of the terms of the proposed amendments to the exemption procedures only formalize current unwritten positions and requirements that the DOL now imposes on applications for exemptions, the proposed amendments would obviously make it more difficult and expensive to apply for a prohibited transaction exemption and put the success of an application in more doubt. As indicated by the diminishing number of exemptions granted in the past two decades, this tightening of the requirements reflects a continuation of the hardening in the DOL’s position with respect to the benefits community that has been underway for at least that long. If finalized, the changes will restrict the ability of the benefits community to obtain exemptions for transactions that facilitate efficient plan administration, and provide for favorable investments, to the detriment of plans. Further, the proposed amendments effectively discourage the benefits community from proactive, informal communication with the DOL and reduce the Department’s understanding of current issues and transactions and reduce the public’s understanding of the Department’s views.
The DOL could also move to apply the new substantive obligations and restrictions outside the context of prohibited transaction exemption applications. For example, the DOL might seek to impose similar requirements on an independent trustee and an independent appraiser involved in an employee stock ownership plan transaction in the context of investigations or enforcement actions regarding the transaction.
Concerned stakeholders should be prepared to submit comments to the DOL on or before the May 29, 2022 deadline. We expect and hope the DOL to consider the issues raised during the comment period and to carefully evaluate ways in which to improve the procedure for the benefit of plans and participants.]]>
In Hughes v. Northwestern University, 142 S.Ct. 737 (January 24, 2022), the Supreme Court held that fiduciaries to self-directed defined contribution retirement savings plans are responsible for determining the prudence of all investment alternatives offered on a plan’s investment menu. While the holding is facially consistent with the core fiduciary principles in the Employee Retirement Income Security Act (“ERISA”), 29 U.S.C. §1101 et. seq., the devil is often in the details; the plans at issue had over 400 available options during the relevant time period, and the Court rejected the notion that fiduciary duties were met if there were enough prudent low-fee options available for participants to design diversified investment portfolios.[1] The Court directed the Seventh Circuit to consider whether plaintiffs had plausibly alleged that fiduciaries had failed to properly evaluate the fees and appropriateness of the offered investment alternatives.[2]
Going forward, the high standard of fiduciary responsibility embraced by the Court in Hughes may discourage fiduciaries from designating numerous investment alternatives on participant investment menus. Fiduciaries considering less robust plan investment menus, however, may also be concerned that reduced investment options could discourage participation or could trigger challenges from participants that investment options are too restrictive.
Could adding brokerage window options expand investment options while reducing fiduciary responsibility for reviewing investment menus? Brokerage window arrangements allow plan participants to direct investment of their plan accounts outside of offered alternatives. Brokerage windows are excluded from the definition of designated investment alternatives in investment menus for self-directed individual account plans,[3] and participants select and evaluate their own investments through the window, typically without investments being vetted or monitored by plan fiduciaries. While there is limited regulatory guidance on the use of brokerage windows, the ERISA Advisory Council recently examined the state of the law and concluded that no further regulation is needed. Advisory Council Report to the Secretary of Labor, December 2021, at p. 53 (summarizing findings and recommending no further regulatory action but suggesting that the DOL conduct additional fact finding on participant needs in brokerage window only plans). Brokerage windows could provide an opportunity to offer unfettered investment options coupled with a limited curated investment menu that fiduciaries could readily evaluate and monitor.
Brokerage windows could also serve as a path to allow participants to consider environmental, social and corporate governance factors (“ESG factors”) in making investment choices without fiduciaries needing to designate specific ESG-focused investment alternatives. The debate over the role of ESG factors in selecting and evaluating ERISA plan investments has stalled efforts by the U.S. Department of Labor (“DOL”) to revise its longstanding Investment Duties regulation; final rules promulgated in November 2020 have been criticized for improperly discouraging consideration of ESG factors, while the revised version proposed in October 2021 has been criticized for instead improperly encouraging such consideration. Brokerage windows could allow participants to use ESG factors to direct their investments without plan fiduciaries having to take a position on the proper role of ESG considerations or embarking on the difficult task of understanding how ESG factors are used to develop and implement investment strategy.
Can brokerage windows offer a simple fiduciary fix? Not so fast, cautioned the DOL, in commentary discouraging ERISA plan fiduciaries from allowing cryptocurrency investments. In Compliance Assistance Release 2022-01 (March 10, 2022), the DOL expressed serious concerns about the uncertainties and volatility inherent in cryptocurrency investments, citing Hughes for the proposition that fiduciaries cannot allow any imprudent investment options, and strongly suggesting that a cryptocurrency option would not be appropriate. Recognizing that brokerage windows could be used to circumvent designated investment options, the DOL further cautioned that a plan fiduciary who permitted investments in cryptocurrency through a brokerage window should be ready to explain how such a decision was consistent with duties of prudence and loyalty under ERISA. Id. at p.3.
The DOL’s statement that plan fiduciaries could be responsible for the prudence of investment choices made through a brokerage window suggests that fiduciaries retain an undefined level of fiduciary responsibility for the investment of all plan assets, regardless of how participants make their investment directions. While the guidance was in the context of cryptocurrency investments, the underlying policy is not necessarily limited.
The principles supporting the Supreme Court’s decision in Hughes lend credence to the DOL’s suggestion; if fiduciaries are responsible for the prudence of all available investment options—whether there are 10, 50, or 500—it stands to reason that there may be some level of fiduciary responsibility with respect to offered brokerage windows.
The question now is when, whether, and how will the DOL or the federal courts develop standards for plan fiduciaries to apply when designing and monitoring individual account plans with brokerage windows. What types of design functions will fall under the fiduciary umbrella? Will including a brokerage window option in a plan document be considered a settlor or a fiduciary act?
Fiduciaries seeking to use brokerage windows to both limit fiduciary responsibility for vetting investment alternatives and expand available investment opportunities should consider approaching brokerage window design as a fiduciary act, and carefully design rules and safeguards mindful of legal requirements and considering participant demographics, interests, and needs.
Plan sponsors must also be mindful of Code qualification requirements. For example, if a plan sponsor could find some objective way to determine who had a sufficient degree of sophistication and financial understanding to understand cryptocurrency as an investment, there would be a distinct possibility that such a group would be discriminatory under Internal Revenue Code standards for tax-qualified plan benefits, rights, and features provisions.
Approaching brokerage window design as a fiduciary act does not concede that fiduciary duties apply. However, given that ERISA jurisprudence has not yet defined the parameters of responsibility, fiduciaries who exercise their duties of prudence and loyalty in designing brokerage window rules should be ahead of the game and poised to demonstrate compliance as fiduciary standards unfold in light of Hughes and developing DOL policy.
Given that brokerage windows are largely unregulated, fiduciaries might also step back and consider different options, such as whether brokerage windows can be designed within ERISA Section 404(c) rules to capture fiduciary protection from losses, whether 404(c) is the best, or only, way to create a fiduciary shield, or whether Code rules could allow for participant investments outside of plan menu choices through rollovers to IRAs.
The attorneys at The Wagner Law Group are available to assist plan fiduciaries as they consider how to respond to the Hughes decision and recent DOL guidance. Please feel free to contact any of the authors of this Alert, Barry Salkin and Mark Greenstein.
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[1] The defined contribution plans at issue in Hughes were Section 403(b) plans that were historically designed as individual contracts, which might have contributed to the high number of offerings. 401(k) plans, however, are not prohibited from having numerous investment options, and plaintiffs have asserted breach of fiduciary duty claims based on the number of offered investment alternatives.
[2] The Hughes court sidestepped application of the Iqbal/Twombly pleading standard to allegations of breach of fiduciary duty regarding defined contribution plan investment offerings, disappointing many practitioners. District and appellate courts have employed different approaches, resulting in inconsistent decisions across the federal bench.
[3] 29 C.F.R. § 2550.404a-5(h)(4).]]>