The New Fiduciary Rule (5): Discretionary Investment Management | Faegre Drinker Biddle & Reath LLP

Key findings

  • The Department of Labor’s proposed regulation defining fiduciary investment and insurance advice for private sector retirement plans, plan participants and IRA owners (collectively, “retirement investors”) includes three different definitions.
  • These definitions are discretionary investment management, non-discretionary investment advice and recognition of fiduciary status.
  • The least controversial definition is that when an investment professional provides investment management or discretionary services to retirement investors, the investment professional will be a fiduciary under ERISA and the Internal Revenue Code.

The US Department of Labor has released its package of proposed changes to the regulation setting forth the non-discretionary fiduciary advice and conflict and compensation exemptions for investment recommendations to retirement plans, participants (including rollovers) and IRAs.

This post discusses the “discretionary” definition of fiduciary investment advice in the DOL’s proposed fiduciary regulation.

In this regard, the proposal states:

(c) Investment Advice. (1) For purposes of section 3(21)(A)(ii) of the Employee Retirement Income Security Act of 1974 (the Act), section 4975(e)(3)(B) of the Internal Revenue Code revenue (Code) , and this paragraph, a person provides “investment advice” with respect to money or other property of a plan or IRA if the person makes a recommendation about a securities transaction or other investment transaction or any investment strategy involving securities or other investment property (as defined in paragraph (f)(10) of this section) to the plan, plan fiduciary, plan participant or beneficiary, IRA, IRA owner or beneficiary, or IRA fiduciary (retired investor) and the person satisfies paragraphs (c)(1)(i), (ii), or (iii) of this section:

(i) The Person directly or indirectly (eg, through or together with any Affiliate) has discretionary power or control, whether pursuant to an agreement, arrangement or arrangement, with respect to the purchase or sale of securities or other investment property for the Retiree investor;…

For context, if a trustee makes recommendations but they are not acted upon until the retirement investor agrees with the recommendation, that is “non-discretionary” investment advice. (And sometimes called 3(21).) On the other hand, if the adviser can carry out its investment decisions without the approval of the retired investor, it is “discretionary” investment advice or management. (This is sometimes called 3(38).)

In both cases, the adviser is a fiduciary subject to the reasonable person rule and the duty of loyalty. However, there are significant differences in the treatment of financial conflicts of interest that are “prohibited transactions” under ERISA and the Internal Revenue Code. As you can imagine, there are several exceptions (or “exceptions”) to the discretionary investment management prohibited transaction rules due to the control exercised by the fiduciary adviser. For example, PTE 2020-02 provides relief only for financial conflicts arising from non-discretionary advice.

As I said earlier, this is not a controversial definition of a fiduciary advisor. This is largely due to the fact that it has been one of the definitions of fiduciary advice since 1975. For example, the current regulation has the following definition:

(°C) Investment advice.

(1) A person is deemed to provide “investment advice” to an employee benefit plan within the meaning of section 3(21)(A)(ii) of Employee Retirement Income Security Act of 1974 (Act) and this paragraph only if:

(i) ….

(ii) Such person directly or indirectly (e.g., through or together with any affiliate)—

  • Has discretionary power or control, whether pursuant to an agreement, arrangement or understanding, over the purchase or sale of securities or other property for the plan;….

Although the concept in the proposal is generally the same as in the current regulation, there are some differences that are not immediately obvious. Here’s what the DOL said about the similarities and differences in the preamble to the proposal:

This proposed provision is similar to a provision in the 1975 rule that provides fiduciary status for investment advice if a covered recommendation is made and the person making the recommendation, directly or indirectly, has “discretionary authority or control, whether or not pursuant to an agreement or not , arrangement or understanding with respect to the purchase or sale of securities or property for the plan.” The proposal would expand this provision by reference to securities or other investment property of the retired investor, not just an investment through a plan or IRA.

Persons who have discretionary power or control over the investment of the assets of a pension investor must be in a relationship of trust and confidence with respect to the pension investor. In addition, like the 1975 provision, the proposal would extend to circumstances where the person making the recommendation “indirectly (eg, through or together with any affiliate)” has discretionary power or control over securities or other investment properties; in this context, the use of “indirect” generally refers to an arrangement where the affiliate has discretionary power or control.

In other words, if the adviser or an affiliate of the adviser has discretion over other non-pension investments of a pension investor, the DOL proposal says the adviser is already in a relationship of trust and confidence with the pension investor, and therefore any advice given to the pension investor investor regarding pension assets, would be fiduciary advice. For example, if an adviser only manages an investor’s personal assets, that adviser will automatically be a fiduciary for any recommendations made about retirement assets. This is an expansion of the definition in the current regulation. But it is unclear how impactful it would be, as the proposal already defines one-off advice to a pension investor as fiduciary advice.

Final thoughts

This definition is most likely to affect registered investment advisers, as other types of financial professionals are limited in their ability to manage discretionary investments. However, registered representatives of broker-dealers are permitted limited discretion under the SEC’s interpretation regarding only incidental advisory services. The DOL has a broader definition of discretion, which means that in some cases broker-dealers and their representatives can be discretionary fiduciaries. This can happen when they have limited discretion over the client’s IRA investments.

The next step in the regulatory process is for interested parties to submit comments. They are due by early January 2024 and will be posted on a public DOL website. At this point we will be able to see if the modified definition is more controversial than I think.

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