On May 22, 1997, the Department of Labor ("DOL") issued two advisory opinions regarding the payment of fees, including 12b-1 fees, by mutual funds to (1) a bank serving as trustee of a plan that has invested in the mutual funds and (2) a provider of recordkeeping and other services to a plan investing in the mutual funds. ERISA Advisory Opinions 97-15A and 97-16A. These opinions, when read together, provide a comprehensive overview as to when such payments would not result in violations of the prohibited transaction rules of ERISA.

In general, the effect of these advisory opinions should be to permit financial institutions that service plans to continue their existing practices of receiving mutual fund fees attributable to investments by their plan clients. The opinions do not require the financial institution to offset such fees against its fees for plan services on a dollar-for-dollar basis to avoid an ERISA violation, unless the institution is acting as a fiduciary in the plan’s selection of the mutual funds as investments. To avoid acting as a fiduciary, the institution would need, among other things, to provide sufficient advance notice to an independent plan fiduciary of any change in its mutual fund "menu".

In discussing these issues, the opinions provide insight and clarification on several issues relating to fiduciary status and the scope of prohibited transactions under ERISA.

This issue had been pending at DOL since July 1994, when a request for an advisory opinion was filed with DOL by Frost National Bank. By that time, it was common industry practice for mutual funds to pay 12b-1, shareholder servicing and other types of fees to financial institutions whose customers invested in those mutual funds. The financial institutions were providing shareholder and other services to the mutual funds in return for those fees, and those services generally overlapped with the trust and recordkeeping services provided by these institutions to their clients. At the time Frost requested an opinion, this practice was beginning to be extended to ERISA plans.

Banks serving as trustees of ERISA plans accepted mutual fund fees under several different arrangements and legal theories, some of which were considered relatively aggressive at the time in view of existing DOL interpretations of the ERISA prohibited transaction rules. The more conservative position was for the bank

to offset any mutual fund fees it received against fees owed to it by investing plans for trust services, on a dollar-for-dollar basis, to avoid any benefit to the bank. Another relatively conservative position was to treat the mutual fund fees as part of the compensation received by the bank for plan services, without the need necessarily for a dollar-for-dollar offset but subject to a reasonableness standard. A position that was considered still more aggressive was to view the receipt of the mutual fund fees as being outside ERISA, and therefore not subject to the prohibited transaction rules.

The prohibited transaction rule that generated the most concern was section 406(b)(3), which prohibits a fiduciary with respect to a plan from receiving any consideration for his or her personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan. Several individual exemptions granted in the late 1980s and early 1990s suggested that this provision could be violated even if the fiduciary passed through the fee to the affected plan on the same day it was received. In addition, while an early DOL interpretation indicated that there should be no section 406(b)(3) violation if the fiduciary was not acting in a fiduciary capacity on behalf of the plan in the particular transaction, later DOL statements and exemptions implied that section 406(b)(3) could be violated even if the fiduciary had no active fiduciary role.

The Frost opinion request presented a factual situation in which the bank would offset any mutual fund fees it received on a dollar-for-dollar basis. Frost acknowledged its fiduciary status as trustee of the plans. In December 1994, Aetna Life Insurance Company filed an opinion request on a related but narrower issue, where the mutual fund fees were received by a party that provided plan recordkeeping and administrative services but was not a fiduciary (although possibly affiliated with one). Two other opinion requests, one submitted jointly by the Investment Company Institute on behalf of the mutual fund industry and the American Bankers Association on behalf of the banking industry, were filed in the fall of 1996 to describe a broader range of practices and service relationships to the DOL staff.

DOL has now responded to the Frost and Aetna opinion requests. These responses also reflect the broader range of issues discussed with the other requesting parties.

The two letters issued by DOL describe two distinguishable fact patterns. ERISA Adv. Op. 97-15A, addressed to Frost, assumes that the bank is a fiduciary to the plans it serves by the nature of its position, even where a directed trustee. ERISA Adv. Op. 97-16A, addressed to Aetna, assumes that Aetna is not acting as a plan fiduciary. Nevertheless, the two, which cross-reference each other, are best analyzed together to formulate a comprehensive overview of DOL’s position on several fiduciary status issues and the scope of the section 406(b) prohibited transaction rules.

The Frost letter states that Frost, as a trustee, is a fiduciary with respect to the plans it serves. According to DOL, the position of trustee, by its very nature, requires its holder to perform one or more of the functions described in the definition of a fiduciary in ERISA (section 3(21)(A)). DOL added that this is the case even for a "directed" trustee who is subject to the proper directions of a named fiduciary under section 403(a)(1) of ERISA, because a directed trustee has residual fiduciary responsibility for determining whether a given direction is proper and whether following the direction would result in a violation of ERISA.

This position has been stated in several other DOL pronouncements, including several recent letters, so it is not new. The Frost letter simply reaffirms and clarifies this view.

The Aetna letter describes the recordkeeping and administrative services that Aetna provides, and indicates that Aetna did not believe that these services would cause it to be a fiduciary. Aetna did ask, however, whether the relationship of its recordkeeping affiliate to an Aetna affiliate that exercised authority or control over plan assets in insurance company separate accounts, which would make that affiliate a fiduciary to the plans investing in those accounts, would cause the recordkeeping affiliate to be a fiduciary. DOL responded that because there was no indication that the recordkeeper is in a position to, or in fact does, exercise any authority or control over those assets, it would not be considered a fiduciary merely as a result of its affiliation with a person who is a fiduciary.

This statement reflects a long-standing DOL staff position that fiduciary status does not carry over to an affiliate. However, this position had not previously been formally stated.

Frost’s request letter raised the issue of Frost having "discretion" where it would select a range of investment funds for plans to choose from as investment alternatives and monitor the performance of those funds, possibly adding or substituting funds over time. The DOL staff then raised this issue with each of the other parties requesting an opinion on mutual fund fee payments.

The underlying issue is whether a bank acts as an ERISA fiduciary in putting together a "menu" of mutual funds from which independent plan fiduciaries can select plan investment options. We have advised our clients that a bank’s (or any financial institution’s) role in formulating the menu is a non-fiduciary business activity, because the bank is acting out of business considerations in developing a product for its customers and does not take into account the needs or circumstances of any particular plan. The DOL staff was concerned, however, about the process by which the bank can make changes to the menu that affect the mutual funds in which the plan is currently invested. In the staff’s view, if the bank can cause the plan’s investments to be shifted to another mutual fund, possibly one that pays higher 12b-1 fees to the bank, the bank may be exercising discretion over the plan’s choice of mutual funds that would cause the bank to be acting as a fiduciary.

Consistent with Frost’s representations, DOL treated Frost as a fiduciary where it would advise a plan fiduciary regarding which mutual funds to use as plan investments, by reason of Frost providing "investment advice" within the meaning of section 3(21)(A)(ii) of ERISA. Where Frost would not be providing such advice, however, DOL was unable to conclude that Frost would not be acting as a fiduciary, because of Frost’s right to add or remove mutual fund families that it would make available to plans. Therefore, Frost’s receipt of fees in either case was evaluated on the basis of Frost acting as a fiduciary in connection with the selection of the mutual funds as plan investments.

The Aetna letter examines this issue in greater detail, describing a set of facts under which a person would not be acting as a fiduciary solely as a result of deleting or substituting a fund from a menu. For that person to avoid being a fiduciary in that capacity, an appropriate plan fiduciary (other than the person) must in fact make the decision on behalf of the plan whether to accept or reject the change. That fiduciary must be provided with advance notice of the change, including any changes in the fees received, and be afforded a reasonable period of time within which to decide whether to accept or reject the change and, in the event of a rejection, to secure a new service provider. The time period for advance notice and changing service providers described in the Aetna letter was 120 days (60 days for the notice and 60 days to effect the change), although DOL added that what constitutes a "reasonable period" will depend on the particular facts and circumstances of each case.

While not discussed in the Frost letter, this standard can be readily applied to a bank serving as a plan trustee (as well as any other financial institution). Therefore, if a bank provides reasonable advance notice of any change in its mutual fund menu and affords a reasonable period of time for an independent plan fiduciary to decide whether to accept or reject the change, and to make new arrangements if it rejects the change, the bank should not be acting as a fiduciary in making that change to the menu. Avoiding acting as a fiduciary in that capacity is a key factor in determining whether the receipt of mutual fund fees violates sections 406(b)(1) or (b)(3).

The principal issue in the letters was whether the receipt of 12b-1 and other fees from a mutual fund in which a plan invests violates either section 406(b)(1) or section (b)(3) of ERISA. The letters also discussed relevant considerations in applying the general standards of fiduciary conduct to these arrangements.

The letters deal with three fact patterns (the first two in the Frost letter and the third in the Aetna letter):

• Fees Received by Trustee Who Advises on Mutual Fund Selection. The plan trustee would advise an independent plan fiduciary about the mutual funds to use as plan investments, and would therefore be acting as a fiduciary. The trustee would disclose in advance the extent to which it may receive fees from mutual funds it recommends, and those fees would be used either (a) to pay all or a portion of the compensation that the plan is obligated to pay to the trustee, or (b) to the extent the fees exceed the plan’s liability to the trustee, to be paid over to the plan. The effect of this dollar-for-dollar offset against the fees the plan is obligated to pay is a pass-through of the mutual fund fees to plan investors.

• Fees Received by Trustee Who is Directed Regarding Plan Investments and Does Not Advise on Mutual Fund Selection. As discussed above, DOL was unable to conclude in this case that Frost, as trustee, would not be acting as a fiduciary, due to Frost’s ability to add or remove funds from its "menu". As in the first fact pattern, Frost, as trustee, would pass through the mutual fund fees to the plans.

• Receipt of Fees by Non-Fiduciary Recordkeeper. Here, for the reasons discussed above, DOL concluded that Aetna would not be acting as a fiduciary. Unlike the Frost fact patterns, there was no representation that Aetna would pass through, credit or otherwise offset fees to plans based on its receipt of fees from the mutual funds.

1. Section 406(b)(1) – Section 406(b)(1) of ERISA prohibits a fiduciary from dealing with the assets of the plan in his own interest or for his own account.
   
   In DOL’s view, advising that plan assets be invested in mutual funds that pay additional fees to the advising fiduciary generally would violate section 406(b)(1). However, DOL found no violation in the two Frost fact patterns. Where the mutual fund fees received by the plan trustee are used to offset and extinguish a legal obligation of the plan, or are credited directly to the plan, DOL held that the trustee would not be dealing with the assets of the plan in its own interest or for its own account in violation of section 406(b)(1). This statement is a reaffirmation of a long-standing DOL position and does not change the law in this area.
   
   The Aetna request did not ask for an opinion about section 406(b)(1).
   
2. Section 406(b)(3) – Section 406(b)(3) of ERISA prohibits a fiduciary from receiving any consideration for his personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan.
   
   In analyzing the first fact pattern, DOL found that Frost’s receipt of fees from mutual funds in connection with a plan’s investment in such funds would be used to reduce the plan’s obligation to Frost and would in no circumstances increase Frost’s compensation, and thus would benefit the plan rather than Frost. It was therefore DOL’s opinion that in these circumstances, Frost would not be receiving such payments for its own personal account in violation of section 406(b)(3).
   
   DOL expressed a broader position in dealing with the second fact pattern. According to DOL, if a trustee acts pursuant to a direction in accordance with section 403(a)(1) (direction from a named fiduciary) or 404(c) (direction from a participant in a participant-directed plan), and does not exercise any authority or control to cause a plan to invest in a mutual fund, "the mere receipt by the trustee of a fee or other compensation from the mutual fund in connection with such investment would not in and of itself violate section 406(b)(3)." DOL described this position as similar to its position under section 406(b)(1).
   
   DOL was unable to conclude that Frost was not exercising any discretionary authority or control because of its control over the mutual fund "menu". Nevertheless, because the mutual fund fees would be used to benefit the investing plans, either as offsets of plan obligations or as direct credits, DOL concluded that Frost would not be receiving payments for its own personal account in violation of section 406(b)(3).
   
   In discussing the third fact pattern in the Aetna letter, DOL restated the standard described in the Frost letter and focused on whether Aetna would be acting as a fiduciary to the investing plans. Because it concluded that Aetna would not be acting as a fiduciary, DOL concluded that there would be no violation of section 406(b)(3).
   
   These statements are major developments in DOL’s position on section 406(b)(3). The implications of these statements are discussed below on page 6.
   
3. General Standards of Fiduciary Conduct – DOL added general admonitions to the independent plan fiduciaries overseeing arrangements under which plan trustees or service providers receive mutual fund fees, describing their responsibilities under ERISA’s general standards of fiduciary conduct.
   
   According to DOL, the responsible plan fiduciaries must act prudently and solely in the interest of plan participants and beneficiaries in deciding whether to enter into or continue such arrangements, and in determining which investment options to utilize or make available under the plan. DOL added: "In this regard, the responsible Plan fiduciaries must assure that the compensation paid directly or indirectly by the Plan to Frost is reasonable, taking into account the trustee services provided to the Plan as well as any other fees or compensation received by Frost in connection with the investment of Plan assets."
   
   To meet this obligation, DOL said that the responsible fiduciaries must obtain sufficient information regarding any fees or other compensation that Frost receives to make an informed decision that the compensation is no more than reasonable. They also must periodically monitor the actions taken by Frost to assure, among other things, that any fee offsets to which the plan is entitled are correctly calculated and applied. Similar statements were made in the Aetna opinion (without the reference to the fee offsets).
   
   DOL emphasized the responsibility of the independent plan fiduciary (typically the employer) to obtain sufficient information about the mutual fund fees in making a decision about the reasonableness of the service provider’s compensation. Under this standard, the independent fiduciary should be able to analyze these fees solely in determining the appropriateness of the mutual fund as a plan investment or investment option, without regard to whether the fees are paid to a particular plan service provider. DOL avoided dictating the analysis that the independent fiduciary must make, saying only that the receipt of the mutual fund fees is a relevant consideration in the fiduciary’s decision-making process.
   
4. Securities Laws – There is a footnote in the Frost letter saying that DOL is expressing no opinion as to the propriety of passing through mutual fund fees to plan investors under Federal securities laws. We understand that there were informal conversations about this issue between the DOL staff and the staff of the Securities and Exchange Commission (the "SEC") after the Frost request was submitted, and that the SEC staff had no objection to the pass-through arrangement described by Frost. Nevertheless, there is no formal statement from the SEC staff on this issue.

III.  Implications of DOL Advisory Opinions

The DOL opinions, when read together, provide helpful clarification to the financial services industry that should permit the continuation of existing mutual fund fee practices. While the Frost opinion raises a question about the fiduciary status of an institution that can make changes to a mutual fund "menu" offered to plans, the Aetna opinion provides a framework under which an institution can conclude that it is not acting as a fiduciary when it adds to or deletes from its menu. Banks and other institutions will, of course, have to draw their own conclusions about their particular situations.

The most important contribution of these letters is the clarification of the scope of section 406(b)(3). While there was legal authority prior to the letters supporting the view taken by DOL, there also were several prohibited transaction exemptions that suggested a broader scope. The narrow scope established by these letters indicates that many prior exemptions may not have been necessary.

A significant result of these letters is that a dollar-for-dollar offset of 12b-1 fees is not required to avoid a section 406(b)(3) violation (unless the recipient is acting as a fiduciary). Where mutual funds in which plans invest pay varying levels of 12b-1 fees and the plan investments in those funds are held in omnibus accounts, the required calculations to perform such offsets can be very complex, if not impossible. By avoiding fiduciary status in connection with the selection of mutual funds by their client plans, the banks can avoid the need for such an offset.

Despite the relatively favorable outcome in these letters compared to what some may have feared, it should be kept in mind that the DOL opinions affirm that ERISA applies to these fee arrangements. Some had argued that arrangements between a bank and a mutual fund are outside ERISA and should not be subject to the prohibited transaction rules. DOL has taken the position, however, that the prohibited transaction rules need to be considered in these situations and that the general fiduciary standards apply to the fiduciaries who review and approve these arrangements. The opinions emphasize that these fiduciaries must consider the fact that the trustee or recordkeeper is receiving fees from other sources connected to plan investments. Therefore, it is important that the independent fiduciaries be provided with full disclosure regarding the mutual fund fees to be paid to the plan trustee or other service provider, consistent with representations made by both Frost and Aetna. Aetna represented that it would provide disclosure in the form of a statement describing the services it provides to the mutual funds and the rate of fees paid, and that it would update the disclosure in the event of any material change.