DOL Expands Definition of Fiduciary - Includes Appraisals And Fairness Opinions
The DOL recently issued a proposed regulation on the Definition of the Term "Fiduciary". The regulation creates a 5-part test that must be satisfied for a person to be treated as a fiduciary for rendering investment advice:
The regulation significantly narrows the plain language of section 3(21)(A)(ii), creating a 5-part test that must be satisfied in order for a person to be treated as a fiduciary by reason of rendering investment advice. For advice to constitute ``investment advice,'' an adviser who does not have discretionary authority or control with respect to the purchase or sale of securities or other property for the plan must--
(1) Render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property
(2) On a regular basis
(3) Pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary, that
(4) The advice will serve as a primary basis for investment decisions with respect to plan assets, and that
(5) The advice will be individualized based on the particular needs of the plan.
The proposed regulation changes a 1976 advisory opinion that concluded that an ESOP valuation did not constitute investment advice:
The Department further limited the term ``investment advice'' in a 1976 advisory opinion. Under the facts described therein, the Department concluded that a valuation of closely-held employer securities that an employee stock ownership plan (ESOP) would rely on in purchasing the securities would not constitute investment advice under the regulation.\6\
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\6\ Advisory Opinion 76-65A (June 7, 1976) (AO 76-65A).
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The current regulation has not been updated since its promulgation in 1975. Since that time, however, the retirement plan community has changed significantly, with a shift from defined benefit (DB) plans to defined contribution (DC) plans. The financial marketplace also has changed significantly, and the types and complexity of investment products and services available to plans have increased. With the resulting changes in plan investment practices, and relationships between advisers and their plan clients, the Department believes there is a need to re-examine the types of advisory relationships that should give rise to fiduciary duties on the part of those providing advisory services. In this regard, we note that recent Department enforcement initiatives indicate there are a variety of circumstances, outside those described in the current regulation, under which plan fiduciaries seek out impartial assistance and expertise of persons such as consultants, advisers and appraisers to advise them on investment-related matters.\7\ These persons significantly influence the decisions of plan fiduciaries, and have a considerable impact on plan investments. However, if these advisers are not fiduciaries under ERISA, they may operate with conflicts of interest that they need not disclose to the plan fiduciaries who expect impartiality and often must rely on their expertise, and have limited liability under ERISA for the advice they provide. Recent testimony by the Government Accountability Office noted an association between pension consultants with undisclosed conflicts of interest and lower returns for their client plans.\8\ The Department believes that amending the current regulation to establish additional circumstances where investment advice providers are subject to ERISA's fiduciary responsibilities would better protect the interests of plans and their participants and beneficiaries. As a consequence of the current regulation, the Department's investigations of investment advisers must focus on establishing each of the elements of the 5-part test rather than on the precise misconduct at issue in particular cases. Even if an adviser advises a plan about its investments for a fee, the plan relied upon the advice based upon reasonable belief that it was impartial, and the advice was wholly abusive, the Department must still prove each of the test's five elements in order to assert a fiduciary breach. The Department does not believe that this approach to fiduciary status is compelled by the statutory language. Nor does the Department believe the current framework represents the most effective means of distinguishing persons who should be held accountable as fiduciaries from those who should not. For these reasons, the Department believes it is appropriate to update the ``investment advice'' definition to better ensure that persons, in fact, providing investment advice to plan fiduciaries and/or plan participants and beneficiaries are subject to ERISA's standards of fiduciary conduct.
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\7\ The Department's Employee Benefits Security Administration (EBSA) maintains a national enforcement project designed to identify and correct violations of ERISA in connection with Employee Stock Ownership Plans. One of the most common violations found is the incorrect valuation of employer securities. Another project, the Consultant/Adviser project (CAP) focuses on ERISA violations that may occur in connection with the receipt of improper, undisclosed compensation by pension consultants and other investment advisers. Information on the EBSA's national enforcement projects can be found at http://www.dol.gov/ebsa/erisa_enforcement.html.
The proposed regulation broadens this interpretation to include "an appraisal or fairness opinion", citing in part how one of the most common violations of the DOL's ESOP Enforcement Initiative is the incorrect valuation of employer securities: This provision encompasses the same types of investment-related advice and recommendations as covered by paragraph (c)(1)(i) of the current regulation, except for the following modifications. First, the proposal specifically includes the provision of appraisals and fairness opinions. As discussed above, the Department concluded in AO 76-65A that a valuation of closely held employer securities that would be relied on in the purchase of the securities by an ESOP would not constitute investment advice under the current regulation. However, a common problem identified in the Department's recent ESOP national enforcement project involves the incorrect valuation of employer securities.\9\ Among these are cases where plan fiduciaries have reasonably relied on faulty valuations prepared by professional appraisers.
The Department believes that application of the proposal to appraisals and fairness opinions rendered in connection with plan transactions may directly or indirectly address these issues, and align the duties of persons who provide these opinions with those of fiduciaries who rely on them. Accordingly, paragraph (c)(1)(i)(A)(1) of the proposal specifically includes the provision of appraisals and fairness opinions concerning the value of securities or other property. This paragraph is intended to supersede the Department's conclusion in AO 76-65A, but is not limited to employer securities. Therefore, if a person is retained by a plan fiduciary to appraise real estate being offered to the plan for purchase, then the provision of the appraisal would fall within paragraph (c)(1)(i)(A)(1) of the proposal, and may result in fiduciary status under ERISA section 3(21)(A)(ii). The Department would expect a fiduciary appraiser's determination of value to be unbiased, fair, and objective, and to be made in good faith and based on a prudent investigation under the prevailing circumstances then known to the appraiser.
\21\ The scope of the regulation was further limited by the Department in a 1976 advisory opinion (AO 76-65), in which it concluded that, under the facts described therein, a valuation of closely held employer securities that would be relied on in the purchase of the securities by an employee stock ownership plan (ESOP) would not constitute investment advice under the regulation.
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An adviser's recommendation may involve significant sums and matters of specialized expertise, and it may include professions of impartiality. However, unless the advice meets each element of the current regulation's 5-part test, ERISA's remedies for lack of due diligence and disloyalty are unavailable to the plan.
In contrast, when a fiduciary uses its position of trust to enrich itself by engaging in self-dealing and subordinating the plans' interests to its own, it violates numerous provisions of ERISA, including its duty of loyalty provided in section 404 of ERISA and the prohibitions on self-dealing provided in section 406(b) of ERISA. Such a fiduciary also exposes itself to the broadest possible range of remedies under ERISA.
Applying the current regulation in today's service provider market has had a detrimental impact on EBSA's allocation of its enforcement resources. EBSA seeks to focus its enforcement resources on areas that have the greatest impact on the protection of plan assets and participants' benefits. To accomplish this goal, EBSA requires its field offices to place particular emphasis on certain national enforcement projects. The determination of fiduciary status is particularly important to two national enforcement projects: The Employee Stock Ownership Plan (ESOP) Project and the Consultant/Adviser Project (CAP).
The ESOP project is designed to identify and correct violations of ERISA in connection with ESOPs, which are designed to invest primarily in employer securities. CAP focuses on the receipt of improper or undisclosed compensation by employee benefit plan consultants and other investment advisers. EBSA's investigations seek to determine whether the receipt of such compensation, even when disclosed, violates ERISA because the adviser/consultant leveraged its position with a benefit plan to generate additional fees for itself or its affiliates. When ERISA violations are uncovered, EBSA will seek corrective action for past violations as well as prospective relief to deter future violations.
One of the most critical elements in bringing enforcement actions under the ESOP and CAP initiatives is establishing that a service provider is a fiduciary. In order to make this determination, investigators must gather evidence to support a finding for each element of the five-part test. In all cases, the analysis necessary to determine fiduciary status is very fact-intensive and requires extensive review of plan documents and contracts, client files, e-mails, investment documentation, accounting records, and interview statements to be obtained from service providers and their affiliates. Consequently, EBSA investigators routinely devote disproportionate time and resources establishing all elements of the five-part test, rather than focusing on the precise misconduct at issue in particular cases.
Based on the foregoing, the Department has determined that regulatory action is necessary to adopt a definition of the term ``fiduciary'' that more closely reflects the broad statutory definition of the term, recognizes the diverse and complex fee practices that exist in today's service provider market and their potential conflicts, accounts for the shift from DB to DC plans, expands the scope of fiduciary protections for plans and their participants and beneficiaries, and permits EBSA investigators and attorneys to focus their efforts on the adviser's conduct rather than meeting the evidentiary requirements necessary to prove that all elements of the current regulation's five-part test are satisfied. As discussed in further detail below, the Department believes that amending the current regulation by broadening the scope of service providers that would be considered fiduciaries would enhance the Department's ability to redress service provider abuses that currently exist in the market, such as undisclosed fees, misrepresentation of compensation arrangements, and biased appraisals of the value of employer securities and other plan investments.
Appraisals and Valuation Opinions: As discussed earlier in this preamble, EBSA's national ESOP enforcement project is focused on identifying and correcting violations of ERISA in connection with ESOPs, which are designed to invest primarily in employer securities. A common violation found in the ESOP national enforcement project arises in cases where plan fiduciaries have reasonably relied on faulty valuations of securities prepared by professional appraisers. The proposed rule, which would supersede AO 76-65A, and therefore would apply to appraisals and fairness opinions rendered in connection with plan investment transactions would align the duties of persons who provide appraisals with those of fiduciaries who rely on these appraisals. As noted above, the provision in the proposed rule is not limited to employer securities.
A Profit Sharing/401(k) Council of America memo explores some nuances of the regulations: The proposal applies to "an appraisal or fairness opinion" – an activity not covered in the current rule. In the preamble the DOL explains that the change addresses their concerns about the valuation of employer securities in an ESOP, but it applies to all plan assets, such as real estate. The DOL states that the provision supersedes Advisory Opinion 76-65A that holds that valuation of closely held securities used in establishing an ESOP is not a fiduciary activity. What's interesting is that AO 76-65A discusses a valuation for a company "considering the sponsorship of an ESOP." The DOL concludes that "Where a plan is not yet in existence, a fiduciary relationship within the meaning of section 3(21)(A) cannot be established." It remains to be seen if the DOL intends to apply a fiduciary standard to what is generally considered to be a settler function, or does it intend to apply the standard only when the plan is established? In either event, regardless of its merits, this new standard will very likely increase costs for these valuations.
Of course, a consequence of making ESOP appraisers fiduciaries is a significant increase in the cost to establish and maintain an ESOP. This could also drive some appraisers out of the industry, likely increasing the cost even further.