Investigations Intensify

Art by Tim Bower

ADVISER QUESTION: I provide investment advisory services to ERISA [Employee Retirement Income Security Act] plans. If the DOL [Department of Labor] were to conduct an investigation of my services to retirement plans, what would it be focused on, and what factors would increase my risk of liability?

ANSWER: The DOL is focused on ERISA violations and especially prohibited transactions. This means you should pay particular attention to both your direct and indirect compensation, and any affiliated services and/or proprietary products.

In recent DOL examinations, we have seen a particular focus on compensation and fee arrangements. This is because the DOL is looking for self-dealing transactions. Under the self-dealing rule, a fiduciary adviser is prohibited from using his fiduciary status to cause himself or an affiliate to receive additional compensation or to receive compensation from a third party in connection with transactions involving plan assets—e.g., from providers or investments.

If a fiduciary adviser commits a self-dealing prohibited transaction, he must pay back the prohibited compensation, plus interest on that amount. He must also file a Form 5330 with the IRS and pay an excise tax of 15% of the amount involved. This increases to 100% if the prohibited transaction is not resolved in a timely fashion. In addition, if the DOL steps in, it could assess a 20% penalty on the “amount involved,” that is, on the prohibited compensation. In sum, committing a prohibited transaction is costly.

Here is an example of a self-dealing prohibited transaction that is on the DOL’s radar: An adviser commits a self-dealing prohibited transaction if he recommends an investment that causes an affiliate to receive a commission or other compensation. For this reason, in recent DOL examinations, the department has been requesting detailed information about investment vehicles—including limited partnerships, mutual funds and collective investment funds—managed by an adviser or its affiliate. The DOL’s focus is on whether these investment funds are recommended to the ERISA plan client and, if so, whether there is a fee paid by the fund to the adviser or affiliate that manages the fund. If that’s the case, the adviser is engaged in a self-dealing prohibited transaction.

To avoid this result, the adviser will need to use a prohibited transaction exemption (PTE), if one is available. For example, PTE 77-4 can be used if an adviser recommends a proprietary open-end mutual fund. However, PTE 77-4 has strings attached, and, to get the benefit of the exemption, those conditions must be satisfied.

But what if there isn’t a PTE? In that case, the adviser can avoid the prohibited transaction by crediting—i.e., offsetting—the investment fund’s management fee, paid by the fund against its advisory fees. The offset must be dollar for dollar. (See the DOL’s Frost Bank Advisory Opinion 97-15A.)

In other DOL examinations, the department has been asking specific questions about disclosures—in particular, about 408(b)(2) disclosures. ERISA’s 408(b)(2) regulation requires that advisers make written disclosures to ERISA retirement plans. The disclosure must describe the adviser’s services, compensation and status—both as a fiduciary and as a registered investment adviser (RIA)—or the engagement and the compensation will be prohibited transactions.

The DOL is paying special attention to the compensation description in the disclosure and evaluating whether it is accurate and complete. Here is specific language from a recent DOL examination where the department is requesting a “schedule of all direct fees (e.g., management fees, advisory fees and consulting fees) and indirect fees (e.g., revenue-sharing fees, referral fees and 12b-1 fees) paid or received by [adviser] or an affiliate or subsidiary of [adviser] for services provided to ERISA clients.”

Based upon these document requests, it is clear that advisers need to pay close attention to indirect compensation and assess whether it is received in connection with services provided to an ERISA plan—before receiving a letter from the DOL.

Fred Reish is chair of the financial services ERISA practice at law firm Drinker Biddle & Reath LLP. A nationally recognized expert in employee benefits law, Reish has written four books and many articles on ERISA, pension plan disputes, and audits by the IRS and Department of Labor. Joan Neri is counsel in the firm’s financial services ERISA practice, where she focuses on all aspects of ERISA compliance affecting registered investment advisers and other plan service providers.