United States: DOL's Latest Attempt To Define Who Is An Investment Advice Fiduciary Under ERISA: Initial Considerations For Asset Managers

After months of anticipation, on October 31, 2023, the U.S. Department of Labor ("DOL" or "Department") unveiled its first new fiduciary rule proposal (the "Proposal") since the Obama administration's 2016 rule. Rebranded the "Retirement Security Rule," the Proposal signifies the latest attempt by the DOL in its ongoing quest to modernize its long-standing fiduciary definition (often referred to as the five-part test). The DOL explained that it is updating the rule to keep up with the substantial evolution of the retirement plan landscape since the rule's adoption in 1975—most notably, the shift away from defined benefit pension plans to individual account plans like 401(k) plans as well as IRAs—and to address perceived gaps in the existing regulatory structure in order to better protect retirement investors. While the Proposal appears to succeed in filling many of these perceived gaps, it would also introduce new uncertainty into many everyday interactions between financial institutions and retirement plans.

This new regulatory package consists of a proposed rule that would revise and expand the definition of investment advice fiduciary along with proposed amendments to various class prohibited transaction exemptions applicable to investment advice fiduciaries (including, PTE 2020-02, PTE 84-24 and others). It is clear throughout the Proposal that a core objective for the Department is to ensure that recommendations made by a person or entity to a retirement investor to engage in a rollover transaction from a plan to an IRA would be deemed fiduciary in nature. However, the approach the DOL has taken in the Proposal would significantly broaden the universe of scenarios and the kinds of advice that would trigger fiduciary status, thereby subjecting affected institutions and individuals (including asset managers of open- and closed-end funds, broker-dealers, and financial advisers) to affirmative duties of loyalty and care under Section 404 of ERISA and to prohibitions under Section 406 of ERISA against specified transactions that present conflict-of-interest potential when dealing with ERISA-covered plans. Fiduciaries to IRAs would need to comply with similar prohibitions on conflicts of interest under Section 4975 of the Internal Revenue Code.

While the Proposal, as written, would greatly alter the marketplace for retirement-related investment products and services, it is important to remember that this is a work in progress—the Proposal has a 60-day notice-and-comment period (as of now, the deadline for submitting comments is January 2, 2024, but there are press reports of financial services industry groups preparing to request an extension), and the DOL also anticipates holding a public hearing on the Proposal approximately 45 days after its publication in the Federal Register. Moreover, it is clear from the public statements made by Department officials that it wants to engage in a dialogue with stakeholders to ensure their voices and concerns are heard.

With that context, we have provided below some initial considerations from the Proposal that may be of interest to asset managers. Note, this alert focuses on the core changes to the scope of fiduciary status, not the changes to the existing exemptions.

I. Reformulation of the 1975 Rule's Five-Part Test

The Proposal would reformulate the current five-part test for determining whether one is an investment advice fiduciary by preserving some of the current rule's attributes while making it harder to avoid fiduciary status. According to the DOL, having to satisfy each of the components of the five-part test has often resulted in financial advisers to participants and beneficiaries being able to skirt fiduciary status under ERISA. In particular, the "regular basis" prong has made it difficult to apply fiduciary status in rollover scenarios where there may only be a single instance of advice as to whether or not an individual should roll over his or her plan account to an IRA. The challenge of trying to ensure these scenarios satisfies the regular basis prong was recently addressed by a U.S. district court judge in Florida in American Securities Association v. United States Department of Labor, 2023 WL 1967573 (M.D. Fla. Feb. 13, 2023)), where the judge struck down a DOL policy interpretation that sought to lower the bar by explaining how "advice to roll over plan assets can also occur as part of an ongoing relationship or at the beginning of an intended future ongoing relationship that an individual has with an investment advice provider." By proposing to eliminate that prong, the DOL is effectively sidestepping this argument.

The chart below compares the requirements of the existing regulation with the requirements that would apply under the Proposal.

Based on the changes, we think the Proposal effectively condenses the 1975 Rule into a three-part test:

• Part 1: Is there a recommendation from a party that regularly makes investment recommendations?
• Part 2: Is the recommendation individualized to the retirement investor?
• Part 3: Could the recommendation objectively be viewed as being made under a relationship of trust in the best interests of the retirement investor?

As the Proposal defines investment recommendations very broadly, this means a large universe of interactions may be fiduciary or non-fiduciary based primarily on the contours of the relationship and interactions between the adviser and the advice recipient. Moreover, the Proposal includes an expansive definition of the statutory phrase "for a fee or other compensation, direct or indirect" that would cover a large, non-exclusive list of different kinds of fees or compensation that the advice provider (or any of its affiliates) receives from any source, with the sole caveat that such fee or compensation has to link back to the recommended transaction or the provision of advice. As discussed further below, the overall impact of the Proposal's reformulation of the 1975 Rule and its articulation of such a wide-ranging definition of "fee or other compensation" is that it creates much more uncertainty than under the DOL's 2016 rule.

II. Investment Recommendations

As the preamble to the Proposal explains, "[w]hether a recommendation has been made is a threshold element in establishing the existence of fiduciary investment advice." In order to answer this question, the Proposal appears to set forth a two-step inquiry:

1. What Is the Subject Matter of the Recommendation? – The first step is based on the subject matter of the recommendation. The Proposal provides a definition that includes three broad categories of recommendations under the umbrella of "making a recommendation of any securities transaction...or investment strategy involving securities or other investment property." The recommendation would have to fall under one of these categories in order to move on to the next step of the analysis.
   1. Post-Rollover Investments – This category includes recommendations as to the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, as to investment strategy, or as to how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
   2. In-Plan Investments – This category includes recommendations as to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., account types such as brokerage versus advisory) or voting of proxies appurtenant to securities; and
   3. Whether to Roll Over – This category includes recommendations as to rolling over, transferring, or distributing assets from a plan or IRA, including recommendations as to whether to engage in the transaction, the amount, the form, and the destination of such a rollover, transfer, or distribution.
2. What Are the Context and Circumstances of the Recommendation? – The second step focuses on the context and circumstances surrounding the recommendation. Although not specifically defined in the regulatory text, the DOL states in the preamble that a recommendation can be seen as "a communication that, based on its content, context, and presentation would reasonably be viewed as a suggestion that the retirement investor engage in or refrain from taking a particular action."
   1. Objective Analysis – Determining whether advice rises to the level of an investment recommendation is an objective inquiry that will depend on the particular facts and circumstances. This analysis requires a holistic analysis of the parties' course of conduct and understandings under the rubric described in Section I above. Despite the key role this determination plays, we do not have clear guidance on how to conduct this analysis, although the DOL noted that the more individually tailored the communication is to a specific retirement investor about a security, investment property or strategy, the more likely the communication will be viewed as a recommendation. In this regard, the DOL points to the framework that the SEC's Regulation Best Interest utilizes with respect to determining whether a broker-dealer has made a recommendation to a retail investor.
   2. No Sophisticated Investor Counterparty Carveout – Under the DOL's 2016 rule, a person would not be deemed to provide "fiduciary investment advice" if the advice is provided to an independent fiduciary of a plan or an IRA who is either a licensed and regulated provider of financial services, or a plan fiduciary with responsibility for the management of $50 million or more in plan assets. As it explains in the preamble to the Proposal, the DOL decided not to include this sophisticated investor carveout based on the rationale that nothing in the statutory text of ERISA suggests Congress intended to "categorically deny fiduciary protections to sophisticated investors." In other words, it appears that the DOL is saying that one would analyze all of the given facts and circumstances of an advice scenario with an objective eye, and that assessment should suffice for not triggering fiduciary status, if the facts and circumstances warrant that conclusion. However, without this carveout, many interactions between retirement plans and financial institutions that have historically been viewed as selling activity may potentially be fiduciary in nature.
   3. The Plan/IRA and Fiduciary as Recipient of the Advice – Another notable change in the Proposal's reformulation of the five-part test is how it describes the recipient of the advice—the retirement investor. Unlike the 1975 Rule, which focuses on the plan as the advice recipient, the Proposal states that when advice is directed to a plan or IRA fiduciary, the relevant retirement investor is both the plan or IRA and the fiduciary. Consequently, discussions between a financial institution and a fiduciary to a plan can become recommendations, even when essentially there are only financial institutions talking to each other.
   4. Wholesaling Activities – Although there is no broad sophisticated investor or selling exemption under the Proposal, the preamble addresses wholesaling activities, where the DOL provides some comfort to product manufacturers or other financial service providers engaging with financial intermediaries who then directly advise plans, participants, beneficiaries, and IRA owners and beneficiaries. The DOL says that such communications would typically fall outside the scope of what it means to be making recommendations that would trigger fiduciary status, because the recommendations would not involve the particular needs or individual circumstances of the plan or IRA serviced by the intermediary. While this language may provide some reassurance, the DOL caveats it with a statement that it would still broadly construe recommendations to plan and IRA fiduciaries acting on behalf of plans and IRAs. Therefore, managers would want to be judicious in their reliance on categorizing their recommendations as non-fiduciary wholesale activities with financial intermediaries under the Proposal's current framework.

III. No Disclaimers

The Proposal explicitly rules out the possibility of utilizing disclaimers as an end-run around fiduciary status under ERISA. In particular, it notes how written statements disclaiming status as a fiduciary under ERISA or the Internal Revenue Code, or disclaiming the conditions set forth in Section I above will not control to the extent they are inconsistent with the advice provider's oral communications, marketing materials, applicable state or federal law, or other interactions with the retirement investor. Yet again, it would depend on the given facts and circumstances surrounding the recommendation that the advice provider gives to the retirement investor.

Footnote

1. 29 CFR 2510.3-21(c)(1)(ii)(B).