Proposed Principal Transactions Prohibited Transaction Exemption | Practical Law

Proposed Principal Transactions Prohibited Transaction Exemption | Practical Law

In connection with the reproposed fiduciary rule issued by the DOL on April 14, 2015, the DOL issued a proposed prohibited transaction exemption that would provide relief under ERISA and the Internal Revenue Code (Code) for investment advice fiduciaries and the financial institutions that employ them to enter into principal transactions with plans and individual retirement accounts (IRAs).

Proposed Principal Transactions Prohibited Transaction Exemption

Practical Law Legal Update 3-609-5533 (Approx. 8 pages)

Proposed Principal Transactions Prohibited Transaction Exemption

by Practical Law Employee Benefits & Executive Compensation
Published on 21 Apr 2015 • USA (National/Federal)
In connection with the reproposed fiduciary rule issued by the DOL on April 14, 2015, the DOL issued a proposed prohibited transaction exemption that would provide relief under ERISA and the Internal Revenue Code (Code) for investment advice fiduciaries and the financial institutions that employ them to enter into principal transactions with plans and individual retirement accounts (IRAs).
In connection with the reproposed fiduciary rule issued by the Department of Labor (DOL) on April 14, 2015, the DOL issued a proposed prohibited transaction exemption (PTE) that would provide relief under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (Code) for investment advice provided by fiduciaries and the financial institutions that employ them to enable them to enter into principal transactions with plans and individual retirement accounts (IRAs) (80 Fed. Reg. 21989 (Apr. 20, 2015)).

Reproposed Fiduciary Rule

On April 14, 2015, the DOL issued a proposed rule that replaces the existing regulatory interpretation of fiduciary investment advice under Section 3(21) of ERISA (80 Fed. Reg. 21928 (Apr. 20, 2015)). This reproposal follows the DOL's initial proposal and subsequent withdrawal of the original proposed fiduciary rule in 2010 and 2011 in response to significant backlash from the brokerage industry regarding the potential impact of the proposed rule, particularly with respect to IRAs. Comments on the proposed rule are due to the DOL by July 6, 2015.
For a detailed analysis of the reproposed fiduciary rule, see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs.

New and Amended Proposed PTEs

Together with the reproposal, the DOL proposed certain administrative class PTEs and proposed amendments to existing PTEs. The intent of these exemptions is to allow broker-dealers, insurance agents and others that act as investment advice fiduciaries to continue to receive a variety of common forms of compensation that would otherwise violate the prohibited transaction rules of ERISA and trigger excise taxes under the Code. The new and amended proposed PTEs include:

Existing Relief for Principal Transactions

In light of the broad scope of the reproposed fiduciary rule, this proposed PTE would provide relief for principal transactions that do not satisfy the existing framework of prohibited transaction relief under ERISA and the Code. Currently, the following statutory and administrative PTEs provide relief in specific circumstances:
  • Blind transactions. While not explicitly stated as an exemption under ERISA or the DOL regulations, the legislative history of ERISA suggests that purchasing or selling a security on an exchange when the buyers and sellers have no knowledge of each other's identity will generally not be considered a prohibited transaction between those parties. The preamble to the proposed principal transactions PTE confirms this analysis, as does Advisory Opinion 2004-05A and Advisory Opinion 92-23A.
  • Eligible Investment Advice Arrangements. Certain principal transactions may be exempted from the prohibited transaction restrictions of ERISA and the Code if they are structured as eligible investment advice arrangements under ERISA Section 408(b)(14) (see Legal Update, EBSA Issues Final Rule on Statutory Exemption for Fiduciary Advisors Offering Eligible Investment Advice Arrangements).
  • Transactions executed over electronic communication network. Certain principal transactions executed using an electronic communication network, alternative trading system, or execution system or trading venue that is subject to regulation and oversight by an applicable federal or foreign entity are eligible for a statutory exemption under ERISA Section 408(b)(16) (29 U.S.C. § 1108(b)(16))).
  • Market-makers Exemption. Part II(1) of PTE 75-1 (71 Fed. Reg. 5883-02 (Feb. 3, 2006)) provides an exemption for the purchase or sale of securities in a principal transaction between an ERISA-governed plan or IRA and a broker-dealer registered under the Securities Exchange Act of 1934. However, it only applies to transactions with broker-dealers if they do not have or exercise any discretionary authority or control (except as a directed trustee) and do not render investment advice under the regulation with regard to the plan or IRA assets (see Practice Note, Prohibited Transactions under ERISA and the IRC: Broker-dealer Exemption: PTCE 75-1).

New Principal Transactions PTE

This new proposed PTE proposes relief for principal transactions in certain widely-held debt securities. Rejecting requested relief for a broad range of principal transactions (such as those involving equities, futures, derivatives, currencies, among others), the DOL instead focused this PTE on debt securities that are widely held and that may need to be sold on a principal basis because particular bond issues may be sold by only a few financial institutions. It is requesting comments on the limitation of this proposed PTE to debt securities.
The proposed PTE would provide relief for investment advisers and financial institutions (including their affiliates) to enter into principal transactions in debt securities with retirement investors, or plans and IRAs when the transaction is a result of the adviser's provision of fiduciary investment advice (for definitions of Adviser, Financial Institutions, Affiliate and Retirement Investor, see Legal Update, Proposed Best Interest Contract Prohibited Transaction Exemption: Advisers, Financial Institutions and Their Affiliates and Related Entities).

Scope of Relief

The proposed PTE proposes relief from ERISA Sections 406(a)(1)(A) and (D) (29 U.S.C. §§ 1106(a)(1)(A) and (D)), 406(b)(1) and (2) (29 U.S.C. §§ 1106(b)(1) and (2)) and the taxes imposed by Code Section 4975 (a) and (b) (26 U.S.C. §§ 4975(a) and (b)). However, it does not provide relief for the receipt of consideration by an investment advice fiduciary from a trading venue in connection with the execution of purchases and sales thereon (also known as "payment for order flow").
It will not provide relief from transactions prohibited under ERISA Section 406(a)(1)(C) (29 U.S.C. § 1106(a)(1)(C)) or the related excise taxes under the Code. It also does not relieve an adviser or financial institution from complying with ERISA Section 408(b)(2) (29 U.S.C. § 1108(b)(2)) and Code Section 4975(d)(2) (26 U.S.C. § 4975(d)(2)).

Limitations

Relief under the proposed PTE is limited to investment advisers whose fiduciary authority regarding the retirement investor's assets involved in the transaction is as a provider of fiduciary investment advice. This means that it does not apply to the receipt of compensation by an adviser for a transaction involving an:
  • ERISA plan if the adviser, financial institution or affiliate is the employer of employees covered by the ERISA plan. This restriction does not include transactions with IRAs.
  • Adviser or financial institution that is a named fiduciary or plan administrator for an ERISA plan, or an affiliate of an ERISA plan, that was selected to provide advice to the plan by a fiduciary who is not independent of them.
  • Advisers who have:
    • full investment discretion for an ERISA plan or IRA assets; or
    • discretionary authority over the administration of the plan or IRA.

Conditions

The proposed PTE contains several conditions that must be satisfied for relief to be provided, including:
  • A written contract. This contract between the adviser, financial institution and retirement investor is the "cornerstone" of the proposed PTE and must be executed before engaging in the initial principal transaction between the parties. There are several prohibited provisions that may not be included in the contract that essentially permit IRA owners to bring a contractual claim to enforce their rights under the proposed PTE (see Contractual Requirements).
  • Transaction conditions. There are a number of general conditions, including that the debt security being bought or sold must not have been issued or, at the time of the transaction, underwritten by the financial institution or any affiliate as well as pricing conditions (see Transaction Conditions).
  • Disclosure requirements. The proposed PTE requires certain disclosures to retirement investors by the adviser or financial institutions before the principal transaction is executed (see Disclosure Requirements).
  • Recordkeeping requirements. The proposed PTE establishes a recordkeeping requirement.

Contractual Requirements

The contract between the investment advice fiduciary, the financial institution that employs that fiduciary (or their affiliate) and the retirement investor is the cornerstone of the proposed PTE. (Regarding advice provided to individual plan participants or beneficiaries, the "retirement investor" is the participant or beneficiary, on behalf of his individual retirement plan account.) It must include:
  • Fiduciary status. The adviser and the financial institution must acknowledge fiduciary status under ERISA or the Code (or both) regarding the investment advice to the retirement investor provided in connection with principal transactions.
  • Impartial conduct standards. The adviser and the financial institution must contractually commit to adhere to impartial conduct in providing this advice. These standards are the same as those imposed under the proposed best interest contract PTE and generally require the adviser to act in the best interest of the retirement investor (see Legal Update, Proposed Best Interest Contract Prohibited Transaction Exemption: Standards of Impartial Conduct ).
  • Warranties. Certain warranties must be made in the contract, including that the adviser and the financial institution will comply with all applicable federal and state laws regarding the rendering of investment advice and the purchase and sale of debt securities.
  • Policies and procedures. The financial institution must also warrant that it has adopted written policies and procedures that are reasonably designed to mitigate the impact of material conflicts of regarding the provision of investment advice to retirement investors regarding principal transactions and that advisers are required to adhere to the impartial conduct standards. These procedures are similar to those required for the proposed best interest contract PTE (see Legal Update, Proposed Best Interest Contract Prohibited Transaction Exemption: Contractual Warranty Regarding Policies and Procedures).
  • Contractual disclosures. Certain disclosures are required to be included in the contract, including:
    • the circumstances under which the adviser and the financial institutions may engage in principal transactions with the retirement investor; and
    • material conflicts of interest associated with the principal transactions.
In addition, certain provisions cannot be included in the contract in order to obtain relief under this proposed PTE. These prohibited provisions include:
  • Indemnifications. The contract may not contain exculpatory provisions that disclaim or limit liability for an adviser's or financial institution's violation of the contract terms.
  • Waiver of class actions. The contract may not require the retirement investor to agree to waive or qualify its right to bring or participate in a class action or other representative action in court in a contract dispute with the adviser or financial institution.
Prohibiting these provisions ensure that IRA owners have a contractual right to enforce the provisions of this proposed PTE.

Transaction Conditions

There are substantive conditions applicable to principal transactions under the proposed PTE, including that:
  • The debt security being bought or sold may not have been issued or, at the time of the transaction, underwritten by the financial institution or its affiliate.
  • The debt security must not include a greater than moderate credit risk and must be sufficiently liquid such that it could be sold at or near its fair market value within a reasonably short period of time.
  • The agreement may not be a part of an agreement, arrangement or understanding designed to evade compliance with ERISA or the Code or to impact the value of the debt security.
  • Consideration for the transaction must be cash. Relief is not provided for transactions executed on an in-kind basis.
  • The purchase or sale of the debt security must be executed at a price that the adviser and financial institution reasonably believe is at least as favorable to the retirement investor as the price available for non-principal transactions. The DOL intends that the proposed PTE permit a comparison between the actual cost to the retirement investor of the principal transaction (including the mark-up or mark-down) and the actual cost to the retirement investor of a non-principal transaction (that is, an agency transaction) in the same or similar debt security. This comparison should be construed in accordance with FINRA Rule 2121.

Disclosure Requirements

Before engaging in the principal transaction, the adviser or financial institution must provide certain disclosures to the retirement investor, including:
  • A statement that the purchase or sale of the debt security will be executed as a principal transaction.
  • Any available pricing information about the debt security, including two quotes obtained by unaffiliated parties.
  • The mark-up or mark-down to be charged in connection with the transaction. The DOL is considering whether to define "mark-up" and "mark-down" as the amount in excess of (or the amount by which the price is reduced) of the "prevailing market price" that a customer pays for a debt security by reference to FINRA Rule 2121 and is requesting comments on this condition.
  • A written confirmation of the principal transaction in accordance with Rule 10b-10 under the Securities Exchange Act of 1934.
  • An annual disclosure that:
    • lists the principal transactions engaged in during the year;
    • provides the prevailing market price at which the debt security is purchase or sold;
    • provides the mark-up or mark-down or other payment for each debt security; and
    • reminds the retirement investor that it may withdraw its consent to principal transactions at any time, without penalty.

Effective Date

The DOL is proposing that compliance with the proposed PTE and the proposed regulation begin eight months after publication of the final regulation in the Federal Register.

Practical Implications

Given the breadth of the reproposed fiduciary rule, this proposed PTE provides necessary relief for common principal transactions involving ERISA-governed plans and IRAs investing in widely-held debt securities. It remains to be seen whether this proposed PTE will be expanded to apply to other types of common principal transactions, and what modifications to the conditions imposed by the proposed PTE will be made before the PTE becomes final.