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Portfolio > Investment VIPs

Prohibited Transactions in a Post-Fiduciary Rule World

By Thomas D. Giachetti

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This is an extended version of the article that appeared in the June 2016 issue of Investment Advisor.

As a result of a new rule by the Employee Benefits Security Administration and the Department of Labor published on April 6, the definition of the term “fiduciary” will change on June 7. The rule impacts those who are fiduciaries to employee benefit plans under the Employee Retirement Income Security Act and retirement plans (including an individual retirement account) under the Internal Revenue Code. The fiduciary rule effectively treats all people who provide investment advice for compensation with respect to assets of a retirement plan or IRA as fiduciaries subject to ERISA’s various protections. 

This should not be confused with an investment advisor’s fiduciary status under the Investment Advisers Act of 1940. Although the two have overlapping commonalities, ERISA contains certain transactions that are per se illegal, whereas most conflicts can be disclosed away under the Advisers Act.

Pursuant to the new rule, a person will be deemed to be rendering investment advice if that person directly or indirectly provides the following types of advice to a plan, plan fiduciary, plan participant or beneficiary, IRA or IRA owner for a fee or other compensation:

  • A recommendation to acquire, dispose of or exchange securities or other investment property

  • A recommendation as to how securities or other investment property should be invested after they are rolled over, transferred or distributed from the plan or IRA

  • A recommendation as to the management of securities or other investment property, including recommendations on investment policies or strategies; portfolio composition; selection of other advisors or managers; selection of investment account arrangements (e.g., brokerage or advisory); or recommendations with respect to rollovers, transfers or distributions

With respect to the investment advice described above, the recommendation is made either directly or indirectly (e.g., through or together with any affiliate) by a person who:

  • Represents or acknowledges that he or she is acting as a fiduciary within the meaning of the Act or the IRC

  • Renders the advice pursuant to a written or verbal agreement that the advice is based on the particular investment needs of the advice recipient

  • Directs the advice to a specific advice recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA

ERISA requires plan fiduciaries to comply with certain fiduciary principles stemming from the law of trusts. These trust principles require that plan fiduciaries act in a prudent manner and with an undivided loyalty to the plans, participants and beneficiaries. In addition to these common law trust principles, fiduciaries must avoid engaging in “prohibited transactions.” Prohibited transactions are statutory prohibitions that fiduciaries cannot engage in without an applicable statutory or administrative exemption.

ERISA and the IRC generally prohibit fiduciaries from receiving payments from third parties and from recommending certain products that increase their own compensation in connection with investment advice rendered to participants and beneficiaries of an ERISA plan, IRA owners and those individuals who act as fiduciaries for an IRA or ERISA plans.

There are only three enumerated prohibited transactions addressing fiduciaries, but the implications are plentiful for investment advisors and managers. The three specific types of prohibited transactions for fiduciaries are:

  • Dealing with the assets of the plan in the fiduciary’s own interest or for the fiduciary’s own account (referred to as “self-dealing provision”)

  • Acting in any transaction involving the plan on behalf of a party whose interests are adverse to those of the plan or its participants or beneficiaries

  • Receiving any compensation for the fiduciary’s own personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan (“anti-kickback provision”)

The self-dealing and the anti-kickback provisions are the most problematic. For example, an advisor who provides advisory services to a retirement plan on a discretionary basis and includes a proprietary mutual fund in the plan’s lineup, and who directly or indirectly receives additional compensation from this recommendation, would be in violation of the self-dealing provision, and would also be subject to certain excise taxes under the IRC.

In addition, under the new fiduciary rule, a recommendation by an investment advisor to an owner of an IRA or retirement plan account that he or she should transition from a commissionable account to a fee-based account is subject to the fiduciary rule and the compensation received as a result could be a prohibited transaction. However, there are certain streamlined procedures under the Best Interest Contract Exemption to comply with this prohibited transaction.

Lastly, and of concern to even the most “plain vanilla” investment advisor, the new fiduciary rule subjects every rollover recommendation to ERISA or the IRC. This is the case even if the rollover recommendation is not specifically accompanied by a recommendation by the advisor on how to invest the assets after the rollover. This is also the case if the assets will not be covered by ERISA or the IRC after the recommendation. Therefore, if the advisor can increase his or her compensation as a result of the recommendation, such recommendation would be a prohibited transaction. However, level-fee fiduciaries (i.e., advisors who provide services only on an “asset under management basis” or “fixed fee” basis that does not vary based on an investment recommended in connection with advisory or management services to the ERISA plan or IRA) are able to comply with the Best Interest Contract Exemption on a streamlined basis. 

When fiduciaries violate ERISA’s fiduciary duties or the prohibited transaction rules, they may be held personally liable for any losses to the investor resulting from the breach. In addition, prohibited transaction violations are subject to excise taxes under the IRC or civil penalties under ERISA. Therefore, it is extremely important to identify these practices and prevent them.

— Read “How to Sell Fixed Indexed Annuities Under DOL Fiduciary Rule” on ThinkAdvisor.

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