Employee Benefits/ERISA-Related Litigation

Financial institutions and advisers that manage retirement plan assets and are subject to the regulations of the Department of Labor (“DOL”) under the Employee Retirement Income Security Act of 1974, as amended, (“ERISA”) regarding fiduciary duties (the “Fiduciary Rule”) may also be subject to state law violations for failure to comply with the Fiduciary Rule. The Enforcement Section of the Massachusetts Division of the Office of the Secretary of the Commonwealth (the “Massachusetts Enforcement Section”) filed an administrative complaint (the “Complaint”) on February 15, 2018 against Scottrade, Inc. (“Scottrade”) claiming violations of a Massachusetts statute due to alleged violations of the Fiduciary Rule.  Given the relief requested in the Complaint and the potential precedent for other states, this action has the potential to be significant, not only for Scottrade, but for other advisers and financial institutions.

Current Status of the Fiduciary Rule

In November 2017, the DOL announced an extension of the applicability date of certain prohibited transaction exemptions under the Fiduciary Rule from January 1, 2018 to July 1, 2019. However, the extension did not apply to the Fiduciary Rule’s “impartial conduct standards” in dealing with retirement investors.  The impartial conduct standards require advisers and financial institutions to give advice that is in the “best interest” of the retirement investor, charge no more than reasonable compensation, and refrain from making misleading statements.

The DOL’s November 2017 announcement also addressed the extension of its temporary enforcement policy through July 1, 2019. Pursuant to the temporary enforcement policy, the DOL will not to pursue claims against fiduciaries who are working diligently and in good faith to comply with the Fiduciary Rule and related exemptions or treat those fiduciaries as being in violation of the Fiduciary Rule and related exemptions.

Contents of the Complaint and Relief Requested

The Complaint alleges that, although Scottrade added new policies to comply with the impartial conduct standards, Scottrade expanded the scale and scope of the sales practices that the new policies were designed to curtail. The new policies stated that “the firm does not use or rely upon . . . contests . . . or other actions or incentives that are intended or reasonably expected to cause associates to make recommendations that are not in the best interests of Retirement Account clients or prospective Retirement Account clients.”  Nevertheless, Scottrade launched two sales contests that ran in violation of these new policies that were designed to ensure compliance with the Fiduciary Rule.  One of the contests placed explicit emphasis on generating retirement assets, which are covered by the Fiduciary Rule.  The Complaint notes that Scottrade “failed to take any meaningful steps to remove retirement assets from the scope of the contests or ensure compliance with the Fiduciary Rule.”

Accordingly, the Complaint charges that Scottrade, by “knowingly violating its own internal policies related to the Fiduciary Rule” and failing to act in good faith to comply with the Fiduciary Rule, violated Section 204(a)(2)(G) of the Massachusetts Uniform Securities Act and the regulations thereunder (the “Act”).  The section of the Act authorizes the imposition of an administrative fine, the suspension or revocation of registration or any other appropriate action if an investment adviser has “engaged in any unethical or dishonest conduct or practices in the securities, commodities or insurance business.”  The Complaint further alleges that Scottrade violated Section 204(a)(2)(J) of the Act because Scottrade “failed reasonably to supervise  . . . investment adviser representatives . . . to assure compliance with this chapter [of the Act].”

The relief requested in the Complaint is extensive. The Massachusetts Enforcement Section requests that an order be entered that, among other things, requires Scottrade  to cease and desist from further conduct in violation of the Act, censures Scottrade, compels Scottrade to disgorge all profits and other remuneration from the alleged violation, and imposes an administrative fine on Scottrade.

Takeaways from the Complaint

The Complaint puts Massachusetts advisers and financial institutions that manage retirement plan assets on notice that state regulators are monitoring compliance with the impartial conduct standards and that the regulators will take action under Massachusetts law to stop conduct that they view as non-compliant. The Complaint should also serve as a warning to all advisers and financial institutions, as regulators in other states may begin to take actions under state law similar to that taken by the Massachusetts Enforcement Section.  Any such actions will be pursuant to state law because the DOL, and not the states, has the authority to enforce ERISA.

To mitigate the risk of a state enforcement action, advisers and financial institutions should first review their internal compliance manuals to ensure that they are consistent with the impartial conduct standards. Second, advisers and financial institutions should review actual practices and procedures to ensure that they comply with the Fiduciary Rule, as well as internal compliance manuals.  Non-conforming manuals and non-compliant practices should be corrected as soon as possible.

Advisers and financial institutions that are compensated based on a fixed percentage of the value of assets under management may want to reconsider that compensation methodology as it could require compliance with a prohibited transaction exemption, such as the Best Interests Contract Exemption (the “BIC Exemption”), which is a component of the fiduciary rule issued by the Department of Labor (the “DOL”) in April 2016 (the “Final Rule”).  While stating in the recently published “Conflict of Interest FAQs” (the “FAQs”) that the ongoing receipt of a fixed percentage of the value of a customer’s assets under management, where such values are determined by readily available independent sources, typically does not require compliance with a prohibited transaction exemption, the DOL cautions that such compensation may still raise conflict of interest concerns and require that the adviser comply with a prohibited transaction exemption.  The FAQs, like the Final Rule, are generally limited to advice concerning investments in employee benefit plans covered by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), individual retirement accounts (“IRAs”) and certain other plans.

By way of example, the DOL reiterates the view set forth in the Final Rule that there is a conflict of interest when an adviser recommends that a retirement investor roll retirement savings out of a plan into a fee-based account that will generate on-going fees for the adviser that he would not otherwise receive, even if the fees do not vary based on assets recommended or invested.  The DOL guidance also states that investment advice to switch from a commission-based account to an account that charges a fixed percentage of assets under management on an on-going basis could be a prohibited transaction.  For purposes of the BIC Exemption, a retirement investor is generally a participant in a plan subject to ERISA or the owner of an IRA.   Under  the BIC Exemption:

  • an “adviser” is an individual who:
    •  is a fiduciary of a plan or an IRA by providing investment advice for a fee and an employee, independent contractor, agent, or registered representative of a financial institution; and
    • satisfies applicable federal and state regulatory and licensing requirements with respect to the covered transaction.
  • a “financial institution” is an entity that employs the adviser or retains him in another capacity and that is:
    •  registered as an investment adviser under the Investment Advisers Act of 1940, as amended;
    •  a bank or similar financial institution;
    • an insurance company that satisfies certain criteria;
    • a broker or dealer registered under the Securities Exchange Act of 1934, as amended; or
    • an entity that the DOL, in a prohibited transaction exemption granted after April 6, 2016, determines is a financial institution.

Because the types of prohibited transactions described above are relatively discrete and the adviser’s provision of subsequent advice generally does not involve a prohibited transaction, the DOL states in the FAQs that advisers and financial institutions need only comply with the streamlined conditions in the BIC Exemption to cover the discrete advice that requires the exemption.  Per question 13 of the FAQs, the streamlined conditions applicable to level-fee fiduciaries include:

  • a requirement that the financial institution provide a written acknowledgement of its and its advisers’ fiduciary status to the retirement investor; and
  • satisfaction by the financial institution and its advisers of the impartial conduct standards with documentation showing the reasons why the advice was considered to be in the best interest of the retirement investor.  The impartial conduct standards require fiduciaries to act in the best interest of their clients, charge no more than reasonable compensation and make no misleading statements.

These streamlined conditions apply to “level-fee fiduciaries” who will receive only a “level fee” in connection with advisory or investment management services provided to a plan or an IRA.  As discussed in the FAQs, a level fee is a fee or compensation that is provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment.

The DOL also states that, after an adviser recommends a rollover to a plan participant, the receipt of level-fee compensation does not violate ERISA’s prohibited transaction rules or require compliance with an exemption.

However, the DOL warns that certain abusive practices could result in a self-dealing prohibited transaction, for which no exemption is available.  The DOL supports this position by citing the October 2013 “Report on Conflicts of Interest” of the Financial Industry Regulatory Authority, which describes various circumstances in which advisers may make inappropriate recommendations intended to promote the advisers’ compensation at the expense of the investors.  For example, recommending a fee-based account to a retirement investor with low trading activity and little need for on-going monitoring or advice would be considered abusive conduct, as such advice would be designed to enhance the adviser’s compensation at the expenses of the investor.

In summary, to mitigate the risk of having to comply with certain provisions of the BIC Exemption or of engaging in a non-exempt self-dealing prohibited transaction, advisers and financial institutions should consider designing compensation programs that are not based on the value of plan assets under management.  Alternatively, if assets under management is key component of an adviser’s compensation plan, then the adviser and financial institution should be certain that they comply with the streamlined conditions of the BIC Exemption.