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DOL "Re-Proposes" Investment Advice Rules; Eliminates Class Exemption

March 2010
Executive Compensation, Benefits, Employment and Labor Focus
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On February 26, 2010, the Department of Labor ("DOL") re-proposed regulations that would implement the statutory exemption for the provision of investment advice to participants and beneficiaries in participant-directed retirement plans (such as 401(k) plans) and individual retirement accounts ("IRAs"), which was enacted as part of the Pension Protection Act of 2006 ("PPA"). The PPA exemption and the proposed regulation generally seek to make professional investment advice more accessible to participants and beneficiaries of individual account plans by permitting a broader array of investment advice providers to offer their services.

Background

Plan Participants. Participant-directed retirement plans provide an opportunity for participants and beneficiaries to select the manner in which the assets in their accounts are invested, typically through the offering of a broad range of investment alternatives. The DOL determined, however, that many individuals in such plans have made poor investment decisions that resulted in higher investment fees, poorly timed trading and/or inadequate diversification.

Investment Advisers. A "prohibited transaction" generally arises when an investment adviser provides investment advice to a plan participant or beneficiary with respect to a plan investment offering that pays the adviser fees and, pursuant to such advice, the plan participant or beneficiary makes investments that generate additional income for the investment adviser. In the absence of a statutory or administrative exemption, the prohibited transaction restriction under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), and related sanctions under the Internal Revenue Code of 1986, as amended (the "Code"), generally precluded conflicted investment advisers from offering investment advice to plan participants and beneficiaries, other than in certain circumstances specifically permitted by the DOL in Interpretive Bulletins or Advisory Opinions. For example, the DOL has issued guidance indicating that (a) investment "education" is not investment advice, (b) the investment advice function can be outsourced to an independent financial expert and (c) certain reductions of investment adviser fees through "fee-offset" approaches can eliminate a prohibited transaction concern.

Statutory Exemption. Responding to the need to afford participants and beneficiaries with greater access to professional investment advice, the PPA created a new statutory prohibited transaction exemption that allows greater flexibility for investment advisers to render investment advice to plan participants and beneficiaries. One of the ways in which investment advice may be provided under the exemption is through the use of a "computer model" that has been certified by an eligible investment expert as unbiased. The other way is through an investment adviser that is compensated on a "level-fee" basis, where the investment adviser's fees do not vary depending on the investment option selected.

Implementing Regulations. In early 2009, during the last days of the Bush Administration, the DOL published final regulations that implemented the statutory prohibited transaction exemption under ERISA and the Code, and permitted an administrative class exemption that granted additional relief under circumstances not encompassed in the statutory exemption. Unlike the statutory exemption, the class exemption (1) permitted investment advisers to provide investment advice "after" the recommendations were generated from a computer model, thereby allowing such advice to vary from that generated by the computer model in a manner that could result in greater income for the investment adviser; and (2) applied the fee-leveling rules solely to employees, agents and registered representatives providing advice on behalf of the investment adviser, and not to the investment adviser as an entity. Concerned that the class exemption would result in "conflicts of interest" for investment advisers, the DOL deferred, and, in November 2009, ultimately withdrew those regulations and the administrative exemption.

New Proposed Regulations

The newly proposed regulations, which are nearly the same as the withdrawn regulations, provide guidance on the statutory exemption's requirements with respect to fee-leveling arrangements and computer model certification. However, they do not provide for the class exemption. Therefore, there is no prohibited transaction exemption for investment advice given after a participant or beneficiary has been provided with a recommendation generated by a computer model. These requirements are summarized below.

Fee Leveling Arrangements
Under a fee-leveling arrangement, no investment adviser (including any employee, agent or registered representative) that provides investment advice may receive from any party (including an affiliate of the investment adviser) any fee or compensation that
is based on a participant's selection of an investment option.
Further, the advice must—

be based on generally accepted investment theories;
take into account fees and expenses related to the recommended investments; and
take into account, to the extent provided to the investment adviser, participant information relating to age, time horizon (e.g., life expectancy, retirement age), risk tolerance, current investments in the plan's offerings, other assets or sources of income and investment preferences.

Observation: In the proposed regulations, the DOL diverged from the wording in the withdrawn regulations to further clarify that the fee-leveling requirement does not extend to affiliates of the investment adviser. Accordingly, an affiliate of the investment adviser may receive fees that vary depending on the investment options selected by a participant or beneficiary, but none of those fees may be passed onto the investment adviser or any of its employees, agents or registered representatives.

Computer Model Arrangements
Investment advisers may provide investment advice by way of a computer model that is designed and operated to—

apply generally accepted investment theories;
take into account fees and expenses related to the recommended investments;
request information from participants and beneficiaries and, to the extent furnished, utilize such provided information;
take into account all investment options under the plan (without giving inappropriate weight to any investment option), and utilize appropriate objective criteria to provide asset allocation portfolios comprised of the plan's investment offerings;

Observation: The computer model need not take into account investment options designed to invest in employer stock, target-retirement-date funds, annuities or brokerage windows.

avoid investment recommendations that inappropriately favor investment options offered by the investment adviser or generate greater income for the investment adviser; and
avoid investment recommendations that inappropriately distinguish among investment options within a single asset class on the basis of a factor that cannot confidently be expected to persist in the future.

Observation: This provision, which was not included in the withdrawn regulations, imposes a limitation on the ability to rely on historical performance, which could result in a significant change to the appropriate criteria generally applied for recommendations of asset allocation. The DOL explained that differences in historical performance are less likely to persist than differences in investment style and fees, and therefore less likely to constitute appropriate criteria for asset allocation. Notably, if past investment performance is not considered an appropriate criterion, recommendations of computer models will seemingly tend to be based, in large part, on low fees and expenses, regardless of historical performance.

Before making the computer model available to plan participants and beneficiaries (following its initial development or substantive modifications made thereto), the investment adviser must obtain written certification from an "eligible investment expert" that the computer model meets the statutory and regulatory requirements (with an explanation of the methodologies applied to reach this conclusion). An "eligible investment expert" is an individual, independent of the investment adviser, who has the appropriate technical training or experience and proficiency to analyze, determine and certify whether the computer model meets the necessary requirements.

Observation: The DOL does not specify the credentials necessary to qualify as an "eligible investment expert." However, the investment adviser has a duty to prudently select an expert to certify its computer model.

Additional Requirements

Several other requirements must be satisfied with respect to the fee-leveling requirement and the computer model arrangement.

Authorization by a plan fiduciary. A plan fiduciary, other than the investment adviser, must expressly authorize the investment advice arrangement.

Annual audits. The investment adviser must annually engage an independent auditor to audit the investment advice arrangements for compliance and, within 60 days following completion of the audit, issue a written report to the investment adviser (and each fiduciary who authorized the use of the investment advice arrangement) setting forth the specific findings regarding compliance.

Observation: Similar to the eligible investment expert, the investment adviser must prudently select an independent auditor.

Disclosure. Prior to rendering advice, the investment adviser must furnish a plan participant or beneficiary with a written notice that includes the following: the role of the parties involved in the development of the investment advice program and selection of investment options available under the plan, all fees or other compensation that the investment adviser or any affiliate is to receive in connection with the advice and several other requirements set forth in the proposed regulations. A model disclosure that may be used by investment advisers accompanies the proposed regulations.

Record Retention. The investment adviser must maintain, for a period of at least six years after the provision of investment advice, any records necessary for determining whether the applicable statutory and regulatory requirements have been met.

Noncompliance

In the event of noncompliance with the proposed regulation, the statutory exemptive relief from the prohibited transaction rules would not apply to the transactions associated with the applicable investment advice. Also, in the case of a pattern or practice of noncompliance, the exemptive relief would not apply to any transaction in connection with the provision of investment advice during the entire period over which the pattern or practice extended.

Effective Date

The proposed regulations will be effective 60 days after publication of the final regulations. Public comments with respect to the proposed regulations are due by May 10, 2010.

Conclusion

The proposed regulations do not require plans to make investment advice available to plan participants and beneficiaries. Rather, the proposed regulations outline approaches for providing investment advice to participants and beneficiaries of participant-directed retirement plans in accordance with the statutory exemption. Notably, the proposed regulations do not invalidate any existing DOL guidance pertaining to acceptable existing means of providing investment advice. Please contact White & Case if you have any questions or concerns regarding how plans may provide investment advice under the statutory exemption or existing DOL guidance.

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