George Michael Gerstein quoted in FundFire on Trump-Era Investment Advice Exemption
The full article can be found here.
The full article can be found here.
The U.S. Department of Labor (DOL) has reinstated the five-part test for when one becomes a fiduciary to retirement investors (e.g., ERISA plan sponsors, participants, IRA owners, etc.) by reason of giving non-discretionary investment advice. While at first blush the reinstatement seems to offer great relief to various financial institutions that were possibly ensnared under the DOL’s tricky 2016 conflicts of interest rule, private fund sponsors, broker-dealers and investment advisers should proceed with caution. Interpretations by the DOL over the second half of 2020 suggests it will liberally interpret (and enforce) the five-part test for when one becomes an investment advice fiduciary. Tellingly, that the Trump administration opted to expansively interpret the five-part test to the point that it has more than a passing resemblance of the 2016 conflicts of interest rule under the Obama administration suggests that, regardless of which party controls the Executive Branch, the risks of becoming a fiduciary have increased and the opportunities to avoid such status have inexorably winnowed.
Under the test, a person provides “investment advice” if he or she: (1) renders advice to a plan as to the value of securities or other property, or makes 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 understanding; (4) that such advice will be a primary basis for investment decisions; and that (5) the advice will be individualized to the plan. In addition to satisfying the five-part test, a person must also receive a fee or other compensation to be an investment advice fiduciary.
All five conditions of the test must be satisfied, plus the receipt of compensation (direct or indirect), for there to be fiduciary investment advice.
The linchpin is that, in order to be an investment advice fiduciary, the financial institution must receive a direct or indirect fee or other compensation incident to the transaction in which investment advice has been provided, in addition to satisfying the 5-part test. The DOL reiterated its longstanding position that this requirement broadly covers all fees or other compensation incident to the transaction in which the investment advice to the plan has been rendered or will be rendered. This could include, for example, an explicit fee or compensation for the advice that is received by the adviser (or by an affiliate) from any source, as well as any other fee or compensation received from any source in connection with or as a result of, the recommended transaction or service (e.g., commissions, loads, finder’s fees, revenue sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to firms in return for shelf space, recruitment compensation, gifts and gratuities, and expense reimbursements, etc.).
Condition #1: “renders advice to a plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property”
The DOL appears to interpret “securities or other property” broadly to include not only recommendations of specific investments but also any recommendation that would change fees and services that affect the return on investments. This means:
But some communications will not, without more, give rise to a “recommendation” under prong #1. These include:
Condition #2: “on a regular basis”
Looks can be deceiving, and that is certainly the case with the “regular basis” requirement. While it would appear to be self-evident, the DOL’s expansive view of this condition should cause service providers to tread carefully. This is because:
On the other hand:
Conditions #3 and #4: “pursuant to a mutual understanding” “that such advice will be a primary basis for investment decisions”
Whether there is a mutual understanding between the parties that communications are—or are not—investment advice turns on the contractual terms and the surrounding facts and circumstances. Here are some markers:
The DOL also confirmed that the advice need only be a primary basis, not the primary basis.
Condition #5: “the advice will be individualized to the plan”
The DOL did not elucidate on this requirement in the new rule. A good rule of thumb, however, is that the more individually tailored the communication is to a specific recipient, the more likely the communication will be viewed as a recommendation by the DOL.
Financial institutions, especially those that believe they do not provide investment advice to retirement investors, should carefully consider whether the DOL’s expansive view of these requirements alters their status as a fiduciary so that they do not inadvertently cause a non-exempt prohibited transaction. An accompanying class exemption goes into effect on February 16, 2021 and would be available for those who become investment advice fiduciaries
1 It is crucial to note that the DOL’s 2016 conflicts of interest rule included an exception for incidental advice provided in connection with counterparty transactions with a plan fiduciary with financial expertise. As the DOL noted then, “[t]he premise… was that both sides of such transactions understand that they are acting at arm’s length, and neither party expects that recommendations will necessarily be based on the buyer’s best interests, or that the buyer will rely on them as such.” The new rule, however, contains no such exception.
2 In the DOL’s eyes, a financial institution that recommends a rollover to a retirement investor can generally expect to earn an ongoing advisory fee or transaction-based compensation from the IRA, whereas it may or may not earn compensation if the assets remain in the ERISA plan.
3 As noted above, the DOL will only treat the marketing of oneself as a “recommendation” if such communication is accompanied by a specific recommendation of a product or service. It is unclear whether the DOL will look for a recommendation of a product or service in fact or in effect, a thorny issue similarly raised under the predecessor 2016 rulemaking.
The article can be found here.
The Biden administration’s Labor Department, potentially led by Marty Walsh, could halt the Trump administration’s efforts to ease regulation of brokers. Read the full Citywire article here.
The U.S. Department of Labor (DOL) has finalized a rulemaking that pertains to proxy voting and the exercise of other shareholder rights with respect to employee benefit plans subject to the U.S. Employee Retirement Income Security Act of 1974, as amended (ERISA).1 The rule applies to plans directly, as well as to commingled investment funds that hold “plan assets.”2 Plan sponsors, investment advisers registered with the U.S. Securities and Exchange Commission (SEC), and other service providers that either exercise shareholder rights on behalf of plans or who appoint those who do should pay particular attention to this final rule.3
As with the DOL’s recent Financial Factors rulemaking, this rule’s genesis was probably the DOL’s concern over the striking growth of environmental, social & governance (ESG) investing. Engagement with a company’s board, for example, is a popular method used by managers to address ESG concerns. But both rules apply much more broadly, including to those managers and mandates that do not take ESG factors into account. Neither this rule nor the Financial Factors rule, is limited to ESG.
The exercise of shareholder rights, including proxy voting, has long been considered fiduciary conduct under ERISA. This rule retains that characterization and defines the scope of responsibilities. In doing so, the rule supersedes DOL Interpretive Bulletin 2016-01 and the relevant portions in DOL Field Assistance Bulletin 2018-01.
As discussed more fully below, fiduciaries of plans and plan asset vehicles will need to review their proxy voting policies and practices regarding their use of proxy advisors, especially when those advisors offer voting recommendations or their platforms pre-populate votes.4 With this rule, proxy advisory firms continue to face increased scrutiny from U.S. regulators, notably the SEC and DOL, over their practices and influence.
From a substantive standpoint, the rule compels fiduciaries to only exercise shareholder rights, including proxy voting, if they are undertaken solely in accordance with the economic interests of the plan and its participants and beneficiaries. This entails the fiduciary discerning some economic benefit to the plan, beyond the plan merely being a shareholder, resulting from the exercise of shareholder activities by the plan alone or together with other shareholders.5 Fiduciaries may consider the longer-term consequences and potential economic impacts from the exercise of such rights, even if they are not currently readily quantifiable, which should strengthen (or at least not hinder) proxy voting and engagement related to material ESG issues.6 Importantly, a discernible economic benefit to the plan must be initially identified to pass muster under the rule, even if the shareholder activity does not result in a direct or indirect cost to the plan.
In the DOL’s view, for example, a fiduciary may have to vote against a shareholder proposal that would result in the issuer incurring direct or indirect costs if such proposal did not also describe “a demonstrable expected economic return” to the issuer. On the other hand, “the costs incurred by a corporation to delay a shareholder meeting due to lack of a quorum is an example of a factor that can be appropriately considered as affecting the economic interest of the plan.”
The costs of proxy voting and other shareholder rights must also be considered, as they too affect the economic interest of the plan. These costs may include direct costs to the plan, such as expenditures for analyzing portfolio companies and the matters to be voted on, determining how the votes should be cast, and ultimately submitting proxy votes to be counted. Moreover, the DOL notes that “[i]f a plan can reduce the management or advisory fees it pays by reducing the number of proxies it votes on matters that have no economic consequence for the plan that also is a relevant cost consideration.”7 Indirect costs are also relevant. For example, the fiduciary should consider the opportunity costs of the exercise of shareholder rights, such as opportunity costs for the client resulting from restricting the use of securities for lending to preserve the right to vote.8
The rest of the rule is more process-oriented, which speaks to how fiduciaries can satisfy these substantive obligations in practice.
First, fiduciaries need to evaluate material facts that form the basis for any particular proxy vote or other exercise of shareholder rights. Here, fiduciaries should consider material information that is known by, available to, or reasonably should be known by the fiduciary. In this respect, the DOL pointed to the fact that, under recent SEC guidance, clients of proxy advisory firms may become aware of additional information from an issuer that is the subject of a voting recommendation, and that an ERISA fiduciary would be expected to consider the relevance of such additional information if material.
Second, fiduciaries must maintain records on proxy voting activities and other exercises of shareholder rights. For fiduciaries that are SEC-registered investment advisers, the DOL intends that these recordkeeping obligations would be applied in a manner that aligns to similar proxy voting recordkeeping obligations under the U.S. Investment Advisers Act of 1940, as amended (Advisers Act).
Third, and as applicable, fiduciaries must exercise prudence and diligence in the selection and monitoring of (i) investment managers charged with proxy voting and (ii) proxy advisory firms selected to advise or otherwise assist with exercises of shareholder rights, such as providing research and analysis, recommendations regarding proxy votes, administrative services with voting proxies, and recordkeeping and reporting services. The fiduciary should consider the qualifications of the service provider, the quality of services being offered, and the reasonableness of fees charged in light of the services provided. ERISA fiduciaries should also ensure that, when considering proxy recommendations, they are fully informed of the potential conflicts of interest of proxy advisory firms and the steps such firms have taken to address them (e.g., reviewing proxy advisor conflict of interest disclosures, etc.). Finally, fiduciaries should review the proxy voting policies and/or proxy voting guidelines and the implementing activities of the service provider; this requirement, however, does not require use of custom policies.
Fiduciaries may adopt proxy voting policies pursuant to a safe harbor and, if so, review them periodically for compliance with the rule (e.g., every two years). These policies may not preclude (i) submitting a proxy vote when the fiduciary prudently determines that the matter being voted upon is expected to have a material effect on the value of the investment or the investment performance of the plan’s portfolio (or investment performance of assets under management in the case of an investment manager) after taking into account the costs involved, or, conversely, (ii) refraining from voting when the fiduciary prudently determines that the matter being voted upon is not expected to have such a material effect after taking into account the costs involved. The rule specifically provides two safe harbors, either or both of which may be utilized when deciding whether to vote. The safe harbors are not the exclusive means to satisfy the rule or represent minimum requirements.
In response to concerns raised by some commenters, the safe harbors in the final rule are intended to be flexible enough to clearly enable fiduciaries to vote to establish a quorum of mutual fund shareholders or on other fund matters. On this point, the DOL noted that fiduciaries may also adopt voting policies that consider the detrimental effect on the plan’s investment due to the costs (direct and indirect) incurred related to delaying a shareholders’ meeting. The rule envisions fiduciaries having considerable flexibility in fashioning proxy voting policies and the opportunity to deviate from the policies in certain instances.
Proxy advisors remain top-of-mind for the DOL. The safe harbors are intended to provide fiduciaries the ability to operationalize the rule without having to seek recommendations on a vote-by-vote basis from proxy advisors. The rule prohibits fiduciaries from adopting a practice of following the recommendations of a proxy advisory firm without first determining that such firm or service provider’s proxy voting guidelines are consistent with the fiduciary’s obligations under the rule.9 As with the SEC, the DOL expects fiduciaries, under certain circumstances, to conduct a more particularized voting analysis than what may be conducted under the general guidelines. The DOL acknowledged that some plans rely on proxy advisory firms’ pre-population and automatic submission mechanisms for proxy votes but noted that adopting such a practice for all proxy votes effectively outsources their fiduciary decision-making authority.
The rule continues to recognize and account for the fact that an investment manager of a plan asset pooled investment vehicle may be subject to an investment policy statement that conflicts with the policy of another plan investor. In this case, compliance with ERISA requires the investment manager to reconcile, to the extent possible, the conflicting policies (assuming compliance with each policy would otherwise be consistent with ERISA). In the case of proxy voting, the investment manager generally must vote (or abstain from voting) the relevant proxies to reflect such policies in proportion to each plan’s economic interest in the investment vehicle. Investment managers of pooled funds, however, typically develop an investment policy statement and require participating plans to accept the investment manager’s proxy voting policy as a condition to subscribe, which remains permitted under the rule. The investment manager’s policies would need to comply with this rule, and the fiduciary responsible for the plan’s subscription in the fund would be obligated to assess whether the investment manager’s policies are consistent with this rule before subscribing in the fund.10
As noted above, the rule does not directly apply to investment vehicles that do not hold plan assets, such as mutual funds. The rule, for example, does not require ERISA fiduciaries to scrutinize a mutual fund’s voting practices in which the plan has an investment. The DOL does, however, contemplate that ERISA fiduciaries will consider the mutual fund’s voting policies as part of its overall consideration of the mutual fund as a prudent investment in accordance with the Financial Factors rule. Thus, fiduciaries should consider whether the investment fund’s voting policies are expected to have a material effect on the risk and/or return of an investment.
The rule’s compliance date is Jan. 15, 2021, subject to the following:
1 The rule does not apply to the exercise of shareholder rights on behalf of non-ERISA plans, such as IRAs and governmental plans.
2 Investment companies registered under the U.S. Investment Company Act of 1940, as amended, do not hold plan assets and thus not subject to ERISA or this rule. Hedge funds and other commingled vehicles that fail to satisfy one of the exceptions set forth in the DOL’s plan assets regulation, on the other hand, are subject to ERISA and this rule. Similarly, bank-maintained collective investment trusts are subject to ERISA and this rule.
3 The rule does not apply to proxy voting that is passed through to participants and beneficiaries with accounts holding such securities in an individual account plan.
4 Firms that agree to act as “investment managers,” within the meaning of Section 3(38) of ERISA, should ensure the investment management agreement is clear on who has the responsibility to exercise shareholder rights on behalf of the plan. When the authority to manage plan assets has been delegated to an investment manager, the investment manager has exclusive authority to vote proxies or exercise other shareholder rights, except to the extent the plan, trust document, or investment management agreement expressly provides that the responsible named fiduciary has reserved to itself (or to another named fiduciary so authorized by the plan document) the right to direct a plan trustee regarding the exercise or management of some or all of such shareholder rights.
5 The proposed rule included a requirement that the fiduciary consider only factors that they prudently determine will affect the economic value of the plan’s investment based on a determination of risk and return over an appropriate investment horizon consistent with the plan’s investment objectives and the funding policy of the plan. The DOL eliminated this condition because of its potential compliance costs and that it may not be apparent that a particular vote will affect the plan’s investment return. A similar revision was made to the final Financial Factors rulemaking; thus, even the DOL admits fiduciaries need not be clairvoyant in evaluating how an investment decision, or the exercise of shareholder rights, on some basis (ESG or not) will materially affect the plan’s return in the future. Instead, fiduciaries should follow a thoughtful, prudent process in reaching the position that an investment, or the exercise of rights appurtenant to such investment, is in the economic interests of the plan.
6 As with the Financial Factors rulemaking, the DOL cautioned fiduciaries against taking too elastic an interpretation of economic benefits that could flow to the plan, by noting that “vague or speculative notions that proxy voting may promote a theoretical benefit to the global economy that might redound, outside the plan, to the benefit of plan participants would not be considered an economic interest under the final rule.”
7 The DOL also noted that it would “not be appropriate for plan fiduciaries, including appointed investment managers, to incur expenses to engage in direct negotiations with the board or management of publicly held companies with respect to which the plan is just one of many investors.” It is questionable whether this assertion is supported by the rule itself.
8 The DOL acknowledged that multiple investment managers may be responsible for managing a plan’s assets, and accordingly revised the rule to permit each investment manager to apply the rule to its specific mandate. The DOL noted, however, that “where the plan’s overall aggregate exposure to a single issuer is known, the relative size of an investment within a plan’s overall portfolio and the plan’s percentage ownership of the issuer, may still be relevant considerations in appropriate cases in deciding whether to vote or exercise other shareholder rights.”
9 The fiduciary selecting and using a proxy advisor, therefore, must review the proxy advisor’s voting guidelines against this rule in addition to separately determining whether a specific recommendation necessitates a particularized analysis. The review of the proxy advisor proxy voting guidelines should be addressed at the outset of the relationship with the proxy advisor and when the proxy advisor updates its guidelines (e.g., annually).
10 Uniform policies utilized by the investment manager across client accounts are still permissible under the rule, provided the policies comply with this rule.
The U.S. Department of Labor (DOL) released last week a new class exemption that would provide relief to registered investment advisers, broker-dealers, banks and insurance companies for the receipt of compensation as a result of providing investment advice, including rollover advice, to ERISA-covered plans and individual retirement accounts (IRAs). Also included in this rulemaking package is new guidance from the DOL on its recent reinstatement of the traditional five-part test when one becomes an investment advice fiduciary.
Here we provide a brief overview of this significant rulemaking.
Here are the key takeaways:
Please be on the lookout for our full analysis of this important development after the holidays.