Legislative and Judicial Actions
Art by Irene Servillo
SEC Vets Adviser Outsourced Services
On October 26, the Securities and Exchange Commission proposed new rules requiring that financial-planning and wealth-management advisers vet and monitor vendors to which they outsource a broad array of client-related services. According to the agency, while advisers have always turned to third-party service providers, their increased use of them to lower the costs of doing business requires increased regulation.
“When an investment adviser outsources work to third parties, it may lower the adviser’s costs, but it does not change [the] adviser’s core obligations to its clients,” SEC Chair Gary Gensler said in a statement.
The rule comes amid the growing incidence of advisers using outsourcing in their everyday work with clients. About 32% of registered investment advisers said they outsource some services, up from 27% two years ago, according to a September survey of 550 advisers by FlexShares, a division of Northern Trust.
The new rule broadly applies to what the SEC calls “covered functions,” or outsourced services that could cause a “material negative impact” on clients. The regulator also said the rule applies to services that the adviser must provide in order to comply with federal securities law.
Marcia Wagner, founder of The Wagner Law Group, said the proposal, which is intended to prevent financial advisers from taking a “set it and forget it” approach to outsourcing, could add work and costs for smaller firms that previously have not done the kind of due diligence the SEC now proposes.
“Large investment advisers servicing retirement plan clients are presently devoting significant time and resources with respect to the vetting and monitoring of third-party providers, and the proposed SEC regulations, if adopted, would have a limited impact upon them,” Wagner says. “However, for small firms that have not previously performed the due diligence requirements …, there will very likely be a significant cost increase, whether the adviser exercises increased oversight or brings the previously outsourced functions in-house.”
In a 232-page report, the SEC said the determination of what obligations should be given due diligence would depend on the “facts and circumstances.” It cited examples such as third parties providing: custom indexes; investment risk software or services; portfolio management; trading services or software; and investment advisory services. “An adviser should be overseeing outsourced functions to ensure the adviser’s legal obligations are continuing to be met despite the adviser not performing those functions itself,” the SEC wrote in the proposal.
The public comment period for this proposal is open until December 27. If the proposal is adopted, a 10-month transition period will follow.
About 32% of registered investment advisers said they outsource some services, up from 27% two years ago …
DOL Finalizes ESG Investing Rule for Retirement Plans
The Department of Labor, November 22, announced a final rule permitting retirement plan fiduciaries to consider climate change and other environmental, social and governance factors when selecting investments for defined contribution plans. This overturns a rule enacted under former President Donald Trump that fiduciaries consider only “pecuniary” factors.
Under President Joe Biden, this DOL ruling takes the stance that fiduciaries have an obligation to consider ESG factors to “protect the life savings and pensions of America’s workers and families from the threats of climate-related financial risk.”
Under the rule, fiduciaries may also consider climate change and ESG factors when selecting a qualified default investment alternative and exercising shareholder rights such as proxy voting. The Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights rule comes at the direction of an executive order Biden signed May 20, 2021. It will be effective 60 days after its publication in the Federal Register.
The IRS Extends Determination Letter Program to 403(b) Plans
Starting next June, the IRS will permit either employers wishing to add a new individually designed 403(b) plan, current sponsors of such a plan making major changes or sponsors terminating an individually designed 403(b) plan to request an initial determination letter using the same program employed by 401(k) and other plans qualified under Internal Revenue Code Section 401(a).
Revenue Procedure 2022-40 expands an IRS and Treasury program for approving retirement plans, allowing 403(b)s—which are used by certain public schools, churches and charities—to apply for the same tax-favored treatment as qualified retirement plans.
The implementation of the new rule will be staggered according to IRS employer identification number. Plan sponsors with an EIN ending in 1, 2 or 3 may request a determination letter, starting June 1, 2023. Sponsors with a number ending in 4, 5, 6 or 7 must wait until June 1, 2024; those with a number ending in 8, 9 or 0 must wait until June 1, 2025. Any terminating 403(b) plan, regardless of EIN, may request a plan termination letter, starting June 1, 2023.
Determination letters are often used by qualified retirement plans to seek official approval from the IRS, says Robert Abramowitz, an employee benefits attorney and partner in Morgan Lewis. Though these letters are not required by law, requesting one is standard practice for sponsors of large 401(a) qualified retirement plans.
The letters are essentially an insurance policy against having a plan design that fails to comply with IRS rules as to form. Applying for a letter also permits an employer to discover, through the IRS’ review of the plan, any issues in the plan, which may be corrected going forward or before adopting it.
Having a letter is also a way to avoid IRS audits. Additionally, sometimes a third party, such as a creditor, will ask a sponsor to obtain or share its determination letter as a condition of service, Abramowitz explains.
Abramowitz calls Rev. Proc. 2022-40 “a big change” for the plans and a change to their benefit. It will streamline the process of plan adoption by making it closer to that for qualified retirement plans.
Individually designed 403(b) plans were unable to get approval from the IRS prior to this change, notes David Ashner, an employee benefits attorney at Groom Law Group Chartered.
Abramowitz cautions, however, that, while this is “good news for many,” those sponsors of long-standing 403(b) plans that seek a determination letter may have long-standing problems revealed as part of the process. He explains that sponsors of older plans should “be careful what you ask for. The IRS looks at things carefully.”
He, too, points out that sponsors normally seek determination as part of initial plan adoption to avoid having to correct issues down the road.
Many 403(b) sponsors are institutions such as universities, which often have highly unique plans that go back decades, Ashner says. This change is something 403(b) sponsors have wanted for a long time, and there should “be a lot of interest” in acquiring determination letters, he says.
Recovery of Improper Executive Incentive Pay
The Securities and Exchange Commission adopted a new rule requiring securities exchanges to create and enforce listing standards that demand issuers to recover executive incentive pay that was improperly awarded, sometimes referred to as a “clawback.”
This requirement was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which amended the Securities and Exchange Act of 1934. The SEC issued the new rule in 2015, but renewed the public comment period until this June and then finalized the rule on October 26.
In the event an issuer has to publish an accounting correction, it must recover any executive incentive pay from current and former executives if that pay was predicated on the incorrect accounting information. Further, the firm must do so for the three years prior to the date the issuer was required to prepare the restatement. The issuer must also disclose its compensation recovery policy.
Exchanges must require a written policy for recovering such incentive pay.
The SEC provides for three exceptions to this rule: 1) if the direct expenses of recovery would exceed the amount to be recovered; 2) if the recovery would violate the laws of the firm’s home country; and 3) if the recovery would cause a retirement plan to fail to meet its legal obligations to the IRS. This rule will go into effect 60 days after it is published in the Federal Register.
DOL Rejects ForUsAll’s ‘Tactical Retreat’
The Department of Labor is fighting back against the latest move by retirement provider ForUsAll in an ongoing legal dispute over DOL guidance. In March, the agency cautioned plan fiduciaries and employers against providing cryptocurrency as an investment option within 401(k) plans.
The latest ForUsAll request came in a motion for entry of order of dismissal, filed with the District Court of the District of Columbia. There, on November 1, the retirement plan provider offered to drop its lawsuit against the DOL, as long as the court confirmed that the department’s initial guidance—found in Compliance Assistance Release No. 2022-01—would not be enforced. This would essentially allow fiduciaries and plan sponsors to provide cryptocurrency assets without fear of regulation, ForUsAll said.
The DOL shot back in its defendants’ response, saying ForUsAll misrepresented the guidance to fit its own purposes and that the court has no jurisdiction over the enforcement of “cryptocurrency investment offerings for an indefinite period of time.”
“In short, the parties now all agree that this case should not proceed further,” the DOL said in its response. “The Court should grant Defendants’ [—i.e., the DOL’s—]pending motion to dismiss and reject ForUsAll’s effort at a tactical retreat.”
The battle between the department and ForUsAll is taking place even as the cryptocurrency market faces increased scrutiny by regulators after the collapse of multibillion-dollar exchange FTX on November 8. According to retirement plan fiduciaries and advisers, that case and the related market crash of established cryptocurrencies such as bitcoin have the industry second-guessing recent moves to give retirement plan participants access to digital assets in their 401(k).
ForUsAll originally sued the DOL in June, saying that the guidance calling on fiduciaries and plan sponsors to use “extreme care” in considering cryptocurrency in retirement plans went beyond the DOL’s regulatory authority as provided by the Employee Retirement Income Security Act and, in addition, bypassed the proper comment period. ForUsAll then, as previously mentioned, reversed course.
The DOL response said ForUsAll misrepresented the initial guidance as stating that to allow cryptocurrency in retirement plans “does not violate a fiduciary duty.” What the guidance actually said, according to the department’s response, is that cryptocurrency as an investment option may comply with fiduciary duties and prudence, depending “on the specific circumstances in a given situation.”
Recordkeeper Fidelity Investments and small-business plan-provider ForUsAll currently have plan sponsor clients providing participants with access to cryptocurrency within their 401(k) accounts.
ForUsAll originally sued the DOL in June, saying that the guidance … to use “extreme care” in considering cryptocurrency in retirement plans went beyond the DOL’s regulatory authority …
SEC Updates Rules on Shareholder Reporting And Fund Advertisements
The Securities and Exchange Commission voted, October 26, to adopt significant changes to its mutual fund and exchange-traded fund advertisement disclosure framework.
The new rule and form amendments will require mutual funds and ETFs to transmit “concise and visually engaging shareholder reports” to promote transparent and balanced presentations of fees and expenses in investment company advertisements.
According to the SEC, funds will need to provide shareholder reports that highlight key information, such as fund expenses, performance, and portfolio holdings. To make the reports more effective, the use of graphics and text features will be encouraged.
Funds must tag the information in their reports in a structured data format. The rule and amendments also require funds to make available, both online and for delivery free of charge, certain in-depth information that may be mainly relevant to investors and financial professionals, the SEC says. That information will no longer appear in a fund’s shareholder reports but will remain available to investors on a website identified in the report and must be filed semiannually with the SEC.
“Shareholder reports are among the most important documents that fund investors receive. These reports, however, often are more than 100 pages in length. As a result, a retail investor looking to understand the performance, fees and other operations of a mutual fund or exchange-traded fund may need to sift through extensive financial information,” says SEC Chair Gary Gensler. “Today’s final rules will require fund companies to share a concise set of materials that get to the heart of the matter. Further, today’s final rules are designed to promote transparent and balanced presentations of fees and expenses in investment company advertisements.”
The SEC has also adopted amendments to investment company advertising rules requiring that fee and expense presentations in registered investment and business development company ads and sales literature be consistent with relevant prospectus fee table presentations and be reasonably current. The amendments also address representations of fees and expenses that could be materially misleading.
The amendments will become effective 60 days after publication in the Federal Register, though the SEC will provide an 18-month transition period after the effective date to give mutual funds and ETFs adequate time to adjust their shareholder report and transmission practices. The agency will also provide an 18-month transition period to comply with the amendments to the advertising rules. The rule amendments that address representations of fees and expenses that could be materially misleading will apply on the effective date.
DOL Clears Up Question About Plan Sponsor PEP Member Responsibilities
Plan sponsors that join pooled employer plans managed by a pooled plan provider are not, in most cases, legally liable as the plan administrator and thus not required to purchase a fidelity bond, the Department of Labor wrote in an information letter.
The letter, in reply to a question from the Surety & Fidelity Association of America, clarified the levels of responsibility and costs that plan sponsors participating in a pooled employer plan may offload or avoid when joining a PEP arrangement managed by a PPP, explains Josh Lichtenstein, partner and head of the ERISA [Employee Retirement Income Security Act] fiduciary practice at Ropes & Gray.
“The Department of Labor, I take it from the response … did not view this as a controversial answer,” says Lichtenstein.
Pooled employer plans were created by Congress in 2019 in the Setting Every Community Up for Retirement Enhancement, or SECURE, Act. The plans allow unrelated businesses to participate in one retirement plan managed by a pooled plan provider. The PPP is the plan fiduciary, with discretion for plan administration and investments.
“[Fidelity bonds are] not terribly expensive, but there’s a cost involved with them,” Lichtenstein notes. “And, if you don’t already have one, then there’s also the time involved in going out and obtaining it: You have to go to an insurer, you have to get the fidelity bond contract, you have to read over it and make sure everything is appropriate and that you’re comfortable with everything. While it’s not a huge undertaking to get a fidelity bond, it is a process, and so saving plan sponsors in PEPs from that is one further argument in favor of [them].”
The letter “make[s] it clear that the DOL thinks that interpretation of the new rules with respect to PEPs under the SECURE Act follows from the department’s long-held views under [ERISA] Section 412 more generally for fidelity bonds,” Lichtenstein adds.
“The PEP provider is the administrator of the plan, [and] the plan sponsor and the employees of the sponsor shouldn’t be viewed as handling plan funds or other property as they take the money from the plan participants and remit it to the PEP provider so the provider can actually have it invested in the [participants’] accounts,” he says. “That should not be viewed as handling plan funds or other property in a manner that would require the fidelity bond, so it saves the sponsor from the cost of buying its own fidelity bond … just the bond that the PEP provider has should be sufficient.”
The letter also clarified that the pooled plan provider “has the ultimate responsibility to have that fidelity surety bond,” Lichtenstein says.
Plan sponsors that are now in a pooled employer plan and the pooled plan provider must protect the plan against loss “by reason of acts of fraud or dishonesty on the part of individuals required to be bonded, whether they act directly or through connivance with others,” according to DOL regulations.
SEC Collects Big Time on Enforcement Actions
The Securities and Exchange Commission has collected a record $6.44 billion in disgorgement and penalties during the fiscal year that ended September 30, up from $3.85 billion last year, and easily surpassed the former record of $4.68 billion set in fiscal 2020.
The regulator raked in close to $4.2 billion in civil penalties, nearly three times the $1.46 billion collected the previous fiscal year. However, disgorgement totals were down for the third straight year to about $2.24 billion, from nearly $2.40 billion in fiscal 2021 and $3.59 billion the year before that. In June 2020, the Supreme Court vacated a $26.4 million disgorgement fine the SEC had levied and limited the scope of what it may demand via disgorgement.
But the regulator has more than made up for that with increased penalties. It said it filed 760 enforcement actions in fiscal 2022, up from 697 the year before. Among the enforcement actions, 462 were new or stand-alone actions, up from 434 in fiscal 2021; 169 were follow-on administrative proceedings seeking to bar or suspend individuals from certain functions in the securities markets, up from 143; and 129 actions were against issuers allegedly delinquent in making required SEC filings, up from 120 in fiscal 2021.