Prohibited Transaction Relief

Art by Tim Bower

ADVISER QUESTION: I heard that the Department of Labor [DOL] has adopted a nonenforcement policy. How does it affect the investment advisory services I provide to Employee Retirement Income Security Act [ERISA] plans, plan participants and individual retirement accounts [IRAs]?

ANSWER: The DOL nonenforcement policy provides relief from inadvertent prohibited transactions now that the new DOL fiduciary rule and best interest contract (BIC) exemption have been vacated—i.e., thrown out. The IRS has also adopted the policy for IRAs. However, the policy provides only partial relief, and advisers may want to modify some practices to avoid a prohibited transaction.

When an adviser is a fiduciary to an ERISA plan or an IRA, he is prohibited from receiving certain forms of compensation. Under the prohibited transaction rules in ERISA and the Internal Revenue Code (IRC), two types of compensation are prohibited. One is that received from a third party. For example, if a fiduciary adviser recommends an investment that causes a 12b-1 fee to be paid to himself or an affiliate, the 12b-1 fee is prohibited.

The second type is variable compensation. A fiduciary adviser is prohibited from making recommendations that can generate more compensation to himself depending upon the recommendation. For instance, a fiduciary adviser who receives a commission on each recommended transaction is committing a prohibited transaction. Another example is a fiduciary adviser who recommends a plan rollover to an IRA where he will receive an advisory fee from the IRA. (We discussed the issues with rollovers in our last column, “Rollover Recommendations,” PLANADVISER, May–June.)

As a practical matter, most investment advisers will be considered fiduciaries for their advisory services to ERISA plans and IRAs. Therefore, they will be subject to these prohibitions even though the new fiduciary rule was vacated. This is because the old rule now comes back into effect. Under that, an adviser is a fiduciary if a five-part test is satisfied: The adviser 1) provides advice about investments for a fee or other compensation, 2) on a regular basis, 3) pursuant to a mutual understanding 4) that the advice will be a primary basis for investment decisions and 5) that the advice is individualized based upon the particular needs of the plan or IRA owner. The services provided by investment advisers to ERISA plans and IRAs typically meet these requirements.

How can a fiduciary adviser address these prohibited transaction issues?

One solution would be to utilize an exemption. However, the best interest contract (BIC) exemption was vacated by the 5th Circuit. Unfortunately, there isn’t any other exemption that provides broad-based relief.

An alternative is for the fiduciary adviser to levelize his compensation and avoid the prohibited transaction. For third-party payments, this can be accomplished by offsetting the payment dollar-for-dollar against a level advisory fee. This offset method was approved by the DOL in advisory opinions issued to Frost Bank in the context of an ERISA plan (97-15A) and Country Trust in the context of IRAs (2005-10A). However, the offset method cannot be used for all prohibited transactions. For example, it cannot be used for a plan rollover recommendation that results in payment of an IRA advisory fee.

Another alternative is the nonenforcement policy. Under that, the DOL will not treat an adviser as committing prohibited transactions if he satisfies the impartial conduct standards—i.e., a best interest standard, a reasonable fee and no materially misleading statements. The IRS has also adopted the policy for IRAs. However, the policy does not provide complete relief. First, it does not apply to discretionary investment management. Second, for ERISA plans, it does not protect against private rights of action by plans against advisers. This is not an issue for IRAs because only the IRS can enforce the IRC’s rules.

Clearly, exemptive relief is needed. We anticipate that the DOL will propose an exemption—similar to the nonenforcement policy—at some point in the future, and we hope that it will be retroactive to cover transactions that complied with the policy.

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.