In 2007, the DOL released a proposed regulation under ERISA Section 408(b)(2) that would have required advance disclosure of service provider compensation and potential conflicts of interest to a “responsible plan fiduciary” and the use of written service agreements. After a comment period and public hearings, the DOL finalized the regulation in the fall of 2008 and submitted it to the Office of Management and Budget (OMB) for approval. (This is the final step in the process for approving all federal government regulations.) The OMB failed to act on the submission and with the change of administration from President Bush to President Obama, the regulation was withdrawn by the DOL and remains in limbo. As a result, there is still no mandate for service providers (with a few special exceptions) to use written agreements or make advance fee and conflict disclosures.

Notwithstanding this absence of the regulation, the DOL is using its enforcement authority to impose these requirements on service providers. Consider the following example.

Our client (TPA) is a recordkeeper and third party administrator, but the plan assets are custodied by a third party. In 2007, TPA determined that it could save its clients 25 basis points a year by switching to a different custodian. The new custodian offered to help defray some of TPA’s costs in making the conversion and, after the conversion was complete, began to send TPA revenue sharing payments based on the assets held by the new custodian. TPA had not negotiated for and was unaware that it would be receiving these payments. The principal of TPA consulted with us and asked how they should handle these funds. After some discussion, he decided that the funds would be remitted to the TPA’s clients.

At roughly the same time, the DOL began an investigation of a plan served by TPA. In the course of that investigation, the DOL discovered the revenue sharing payments that had gone to TPA and opened an investigation of TPA. After a lengthy investigation, including several interviews with the principal of the TPA, the DOL concluded that the revenue sharing payments were plan assets, that TPA had failed to remit the payments to its clients on a timely basis and thus owed interest on this amount and that the cost-reimbursement payments made by the custodian constituted impermissible compensation to the TPA. Rather than engage in a lengthy dispute with the DOL, our client acquiesced and paid the additional amounts to its plan clients.

The DOL insisted that the TPA enter into a settlement agreement. Initially, we objected on the basis that it would subject TPA to the 20% penalty under ERISA Section 502(l), which provides that in the case of a fiduciary breach or knowing participation in such a breach, the DOL “shall assess a civil penalty” equal 20% of the “applicable recovery amount.” That amount is the amount recovered from a fiduciary or other party “pursuant to a settlement agreement with the [DOL]” or through litigation.

The DOL finally agreed that it would not impose the penalty so long as the TPA agreed to use a written service contract with its clients and, prior to entering into such a contract, to make disclosures regarding its compensation and potential conflicts of interest. In essence, the DOL imposed through the enforcement process the same requirements that would have been imposed under the 408(b)(2) regulation. Since TPA already used a written service contract and since it was already fully disclosing its compensation, remitting the revenue sharing to the plans for allocation to participant accounts and disclosing potential conflicts of interest, our client was happy to agree to the settlement and the matter was closed without further action.

We are seeing heightened enforcement activity by the DOL against service providers – often in tandem with the SEC where the service provider is a broker-dealer or registered investment adviser – and we anticipate that the DOL will continue to use its investigations as a vehicle for ensuring that the disclosures it deems appropriate are being made by service providers – at least until a regulation mandating disclosure becomes final.

Disclaimer Required by IRS Rules of Practice:
Any discussion of tax matters contained herein is not intended or written to be used, and cannot be used, for the purpose of avoiding any penalties that may be imposed under Federal tax laws.

Source: ERISA Audit Report