dbr may 2012 the final408(b)(2)regulation[1]

Investment Management Group www.drinkerbiddle.com

The Final 408(b)(2) Regulation: Impact on Investment ManagersBy Fred Reish, Joan Neri, Bruce Ashton, Gary Ammon and Brad Campbell

This bulletin discusses the impact of the U.S. Department of Labor’s (DOL) final 408(b)(2)

disclosure regulation on discretionary investment managers – that is, investment advisers

with the authority to manage the assets of ERISA-governed retirement plans. The final

regulation requires various disclosures to be made by an investment adviser to its

ERISA plan clients prior to July 1, 2012. Failure to comply with these new disclosures

could result in substantial penalties, excise taxes and forfeiture of investment

advisory fees. We would be happy to assist you in drafting or reviewing these new

disclosures.

The new disclosure rules apply to any discretionary asset manager for an ERISA-covered

retirement plan who reasonably expects to receive $1,000 or more of direct or indirect

compensation in connection with its services to a plan. Covered plans include both

defined benefit and defined contribution plans, including ERISA-covered 403(b) plans—

covered plans do not include IRAs or retirement plans that allow employers to contribute

to IRAs set up for employees (referred to as SEPs or SIMPLEs). Discretionary managers

include those hired directly by the plan to manage all or some of its assets, and also the

fiduciary managers of “plan asset vehicles”—investments that are themselves subject to

ERISA, and in which a plan invests. Such investments include collective investment funds

or trusts offered by banks, the separate accounts of insurance companies or certain other

investment vehicles (e.g., hedge funds) if more than 25% of the funds being managed

come from ERISA plans and other “benefit plan investors.” The disclosure rule does not

apply to investment advisers for mutual funds because the investments in mutual funds

are not considered ERISA plan assets.

More information is available from earlier Drinker Biddle alerts addressing DOL Reg.

§408(b)(2):

> The DOL’s 408(b)(2) Regulation: Impact on Investment Managers (June 6, 2011) –

see www.drinkerbiddle.com/files/ftpupload/pdf/DOLs408b2Regulation.pdf

> Finally the Final … 408(b)(2) Regulation (February 2012) – see

www.drinkerbiddle.com/files/ftpupload/pdf/FinallytheFinal.pdf

Investment Management Bulletin May 2012

www.drinkerbiddle.com/files/ftpupload/pdf/DOLs408b2Regulation.pdf

http://www.drinkerbiddle.com/files/ftpupload/pdf/FinallytheFinal.pdf

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Key Considerations for Investment Managers

> The disclosures need to be provided in writing to the “responsible plan fiduciary,” defined as the fiduciary of an ERISA-covered retirement plan with the authority to cause the plan to enter into a service arrangement with the investment manager.

> The compliance date is fast approaching – For existing service arrangements, the disclosures must be provided no later than July 1, 2012.

> For new, post-June 30 service arrangements, the disclosures need to be provided reasonably in advance of entering into the arrangements.

> These disclosures are new requirements for the prohibited transaction exemption that permits reasonable arrangements with ERISA retirement plans—failure to provide the disclosures results in a prohibited transaction.

> Investment managers who are subject to these rules and who fail to comply will be subject to excise taxes, may need to refund the compensation, plus interest, they receive under the covered service arrangement, and could be subject to an additional 20 percent penalty imposed by the Department of Labor.

> The rules apply to any discretionary investment manager that provides services as an ERISA fiduciary directly to an ERISA-covered retirement plan or that manages a Plan Asset Vehicle, such as a common or collective trust fund of a bank, a separate account of an insurance company, or certain other investment vehicles if more than 25 percent of the funds being managed come from ERISA plans and other “benefit plan investors.”

> If an investment manager provides ERISA fiduciary services to a Plan Asset Vehicle that is also a “designated investment alternative” (DIA) in an ERISA-covered retirement plan, then the investment manager must also disclose the total operating expenses and certain other information in its possession relating to the performance and fees or expenses of the Plan Asset Vehicle. A DIA is any investment alternative designated by the ERISA-covered retirement plan into which participants can direct the investment of their plan accounts.

> Arrangements with third-party payers that result in indirect compensation payments (e.g., soft dollars or other non-monetary compensation) to the investment manager must be described in sufficient detail that the responsible plan fiduciaries can evaluate their reasonableness.

Overview

The final 408(b)(2) regulation requires detailed disclosures that must be satisfied by

an investment manager that enters into a contract or arrangement to provide “covered

services” to an ERISA-covered retirement plan, such as a 401(k) plan, a defined benefit

pension plan, a non-participant-directed profit sharing plan or an ERISA-covered 403(b)

plan. Covered services include investment management services provided directly to

an ERISA-covered retirement plan as an ERISA fiduciary. Covered services also include

services provided as an ERISA fiduciary to a Plan Asset Vehicle. Finally, covered services

include services provided by a registered investment adviser. For these services, the

disclosure must be provided to the responsible plan fiduciaries of the ERISA-covered

retirement plans.

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The disclosures are enforced through the prohibited transaction rules. Because service

providers are “parties in interest” under ERISA, an exemption from the prohibited

transaction rules is necessary in order for a plan to engage a service provider without

committing a prohibited transaction. ERISA section 408(b)(2) is the prohibited

transaction exemption that permits a plan to engage a service provider that is a party

in interest if the contract or arrangement is “reasonable.” The final 408(b)(2) regulation

adds disclosure requirements as new elements of “reasonableness.” As a result, a

failure by a covered service provider to provide the disclosures will result in a prohibited

transaction under ERISA and the Internal Revenue Code. This means that the investment

manager will be subject to excise taxes and must correct the violation, which may mean

refunding the investment manager’s compensation plus interest on that amount. In

addition, if the DOL recovers the compensation for the plan through either a settlement

agreement or a court order, an additional 20 percent penalty may be imposed.

The disclosures must provide detailed information about the investment manager’s

services, direct and indirect compensation, ERISA fiduciary status, and whether the

manager is an investment adviser registered under the Investment Advisers Act of 1940

or state law. Also, they must be written in a manner that facilitates the responsible plan

fiduciary’s evaluation of the information. The disclosures must be made reasonably in

advance of the date the service contract is entered into, but no later than July 1 in the

case of existing arrangements.

This bulletin focuses on those changes made by the final regulation that impact

investment managers.

1. Effective Date. The compliance effective date of the final regulation was extended

from April 1 to July 1, 2012. The delay benefits investment managers who may not

recognize that they are covered service providers and who therefore may not have

taken steps to comply, such as:

a. Investment managers that provide ERISA fiduciary services to Plan Asset

Vehicles; and

b. Investment managers who manage all or part of the assets of an ERISA-covered

retirement plan such as a profit sharing or pension plan, but who are not

otherwise involved in the retirement plan community.

2. Additional Investment Disclosure for Designated Investment Alternatives. As stated

above, a DIA is generally “any investment alternative designated by the covered plan

into which participants and beneficiaries may direct the investment of assets held

in, or contributed to, their individual accounts,” but does not include brokerage

windows, self-directed brokerage accounts, or similar plan arrangements that allow

participants to select investments not otherwise offered under the plan menu. The

final regulation requires additional disclosures from investment managers that

provide ERISA fiduciary services to a Plan Asset Vehicle that is offered as a DIA in

a participant-directed, individual account plan—such as a 401(k) plan allowing

participant direction of contributions into a collective investment fund. (These

additional disclosure requirements of DIA fiduciary managers, therefore, only

apply in the context of participant-directed, individual account plans, and not to

investments made by traditional pension plans or defined contribution plans in which

there is no participant direction.)

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Under the final regulation, the investment manager of a DIA is required to disclose

the total annual operating expenses of the Plan Asset Vehicle and, if within the

control of or reasonably available to the investment manager, performance data and

fee and expense information required in order for the responsible plan fiduciary to

satisfy the participant-disclosure rules (DOL Reg. §2550.404a-5(d)(1)). This means

that the investment manager will need to provide (i) information on the DIA’s

average annual total return for the one-, five- and 10-calendar year periods ending

in the most recently completed calendar year, (ii) an appropriate benchmark, (iii) fee

and expense information, (iv) the DIA’s principal strategies and principal risks, and

(v) the DIA’s portfolio turnover rate. If the investment manager does not provide this

information, the responsible plan fiduciary is required to terminate the relationship

so as to avoid engaging in a prohibited transaction.

3. Disclosure of Indirect Compensation Arrangements and Compensation Paid to

Affiliates. The final regulation includes disclosure requirements for indirect

compensation. Indirect compensation means compensation received by the

investment manager from any source other than the plan, the plan sponsor, or an

affiliate of the manager, and includes non-monetary compensation. Under these

definitions, indirect compensation includes soft dollars provided by a broker-dealer

to an investment manager in exchange for the investment manager’s executing

of securities transactions through the broker-dealer. Indirect compensation could

also include non-monetary compensation, such as gifts, awards and trips. The

compensation must be quantified in the disclosure (e.g., a dollar amount, a formula

based upon plan assets, or a per-participant charge) so that the responsible plan

fiduciary can evaluate the total amount of compensation, both direct and indirect,

that the investment manager will receive.

In addition to describing the indirect compensation the investment manager

expects to receive, the investment manager must describe the services for which

the indirect compensation will be received, the payer of the indirect compensation,

and the “arrangement” with the payer. Thus, in the example above, the investment

manager would need to describe the arrangement with the broker-dealer under

which the broker-dealer provides soft dollars to the investment manager in exchange

for executing transactions. An investment manager also must disclose payments

among itself and its subcontractors or affiliates, such as an affiliated broker-dealer

and subcontractors, that are either set on a transaction basis (e.g., soft dollars,

commissions, finder’s fees) or that are charged directly against the covered plan’s

investment and reflected in the net value (e.g., Rule 12b-1 fees).

The DOL has stated in the preamble to the final regulation that it “intends the

concept of compensation to be received by a covered service provider, or its

affiliates or subcontractors, ‘in connection with’ a particular contract or arrangement

for services [to] be construed broadly.” The preamble provides the example of a

conference offered by a covered service provider to its plan clients in which the

clients pay a small fee for attendance and another institution pays a larger “subsidy

fee” to defray a portion of the cost of the conference. The preamble indicates that

in some instances the subsidy fee could be considered compensation received

by the covered service provider in connection with the covered service provider’s

arrangement with the plan client.

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4. Responsible Plan Fiduciary’s Obligation to Terminate the Service Contract Upon

Failure to Disclose. Under ERISA’s prohibited transaction rules, the responsible

plan fiduciary is prohibited from permitting a plan to enter into an arrangement

with a service provider unless the arrangement is “reasonable” – which means the

disclosure requirements of the final regulation are satisfied. This means that in

order to avoid engaging in a prohibited transaction, the responsible plan fiduciary

must make sure that each covered service provider furnishes it with the disclosures

and that the disclosures contain the requisite information regarding services,

compensation, fiduciary status and registration status under the Investment Advisers

Act or state law.

Accordingly, the final regulation provides an exemption process for responsible

plan fiduciaries where a service provider fails to provide the required information.

By satisfying the conditions of this exemption, the plan fiduciary will not be liable

for the prohibited transaction. Among the conditions is a requirement that the

responsible plan fiduciary request the information in writing as soon as it learns

of the failure to disclose, and that it identify the service provider to the DOL if

the service provider fails to provide the information within 90 days of the written

request.

The interim final regulation also required that the responsible plan fiduciary evaluate

whether it should terminate or continue the arrangement if the service provider

failed or refused to provide the requested information. In other words, termination

was permissive and in the discretion of the responsible plan fiduciary. The rule

now states that, “If the requested information relates to future services (i.e., services

that will be performed after the end of the 90-day period…) and is not disclosed

promptly after the end of the 90-day period, then the responsible plan fiduciary shall

terminate the contract or arrangement as expeditiously as possible, consistent

with such duty of prudence.” (Emphasis added.)

5. Disclosure of Changes. The final regulation continues to require that the investment

manager disclose changes in information related to its services, status as a fiduciary

and a registered investment adviser, and compensation within 60 days after

the investment manager is informed of the change. Changes to the investment

information, however, may be provided annually.

6. Disclosures for Reporting and Disclosure Purposes. The interim final regulation

required that information needed by the plan administrator of a covered plan to

enable it to comply with its reporting and disclosure obligations under ERISA had

to be provided within 60 days after a written request. The final rule modifies this

to specify that the information must be provided “reasonably in advance” of the

date the plan administrator states in its written request that it must comply with its

reporting and disclosure requirement. For example, the plan administrator must

state when it expects to file its Form 5500, and the investment manager must

provide the information “reasonably in advance” of that date. This presupposes

that the plan administrator has made its written request in time for the investment

manager to do so.

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Conclusion

The final regulation should have limited impact on those investment managers that

already recognize they are covered service providers. However, we are concerned

that many investment managers do not realize that they are subject to these new

requirements. Also, investment managers that provide ERISA fiduciary services to a Plan

Asset Vehicle may not have recognized that they are covered service providers and will

need to act swiftly to comply with these disclosure obligations by July 1 for their existing

service contracts. Such investment managers should also take care to understand and

comply with the expanded requirement in the final regulation to disclose investment

information in their possession regarding designated investment alternatives (DIAs)

associated with participant-directed, individual account plans. An investment manager’s

failure to comply with these rules could result in serious consequences, including

imposition of an excise tax, refunding the investment manager’s compensation plus

interest on that amount, and imposition of a 20 percent penalty.

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© 2012 Drinker Biddle & Reath LLP. All rights reserved. A Delaware limited liability partnership

Jonathan I. Epstein and Andrew B. Joseph, Partners in Charge of the Princeton and Florham Park, N.J., offices, respectively.

This Drinker Biddle & Reath LLP communication is intended to inform our clients and friends of developments in the law and to provide information of general interest. It is not intended to constitute advice regarding any client’s legal problems and should not be relied upon as such.

Investment Management Group

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For more information about the matters discussed in this bulletin, please contact one of the

authors, your regular Drinker Biddle lawyer or any member of our Investment Management

Group.

Authors

Gary D. Ammon(215) [email protected]

Bruce L. Ashton(310) [email protected]

Bradford P. Campbell(202) [email protected]

Joan M. Neri(973) [email protected]

Fred Reish(310) [email protected]

Investment Management Group Partners, Of Counsel and Counsel

dbr may 2012 the final408(b)(2)regulation[1]

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