Public Hearing Transcript
Definition of Fiduciary Investment Advice
March 2, 2011
Department of Labor Auditorium
Ms. Borzi: We're going to start in a couple minutes. So if the first panel would just come up and take their seats up here, that will save us a little bit of time.
Mr. Davis: Okay. The second day of our definition of fiduciary hearing is called to order. We have Panel No. 8, Mr. Goldberg, Ms. Carlisle, Mr. Reilly.
Before we get started though, a couple of administrative announcements. One, it's important that everybody speaks into the microphone. It's really important for the transcript person to be able to hear clearly what everybody is saying so she can capture the words correctly.
Secondly, we had a couple of issues yesterday with people plugging their laptops into the sockets on the wall and having the cord so that it traipsed across the aisle. That's actually an OSHA violation and that would not be a great story to have an OSHA violation at the Department of Labor. So we would strongly encourage you not to do that and power up --
Ms. Borzi: Plus, you'll be removed by our OSHA people.
Mr. Davis: So with those two administrative announcements we will go ahead and get started. Mr. Goldberg with the ESOP Association will start.
Mr. Goldberg: Okay. Thank you.
I am Larry Goldberg and I'm here on behalf of the ESOP Association. We're happy to have the opportunity to get in front of you guys today to talk a little bit about our comments on the regulations or proposed regulations.
First, I'll just mention, the ESOP Association is, as we say in our comments, an organization that has over 1,000 members, largely companies with ESOPs. About 50 percent of the members of the Association are companies with less than 100 employees and those are companies who really hold the key links to jobs in their local communities as well as the larger companies; the same for the larger employers in the Association.
The Association is really committed to helping companies put in great ESOPs with great results for the participants as well as all the other parties to the transaction. So we like the opportunity to be able to talk to you guys about how to improve or address problems that you see in the ESOPs area.
I have really three comments I'd like to -- or three points I'd like to make today to you.
The first one I'm going to talk about is just the Association would be interested in some more clarification about the problems that you've seen with appraisals and I'll talk about that more.
And secondly, we would point out, we're not sure the proposal really will solve the problems that you've identified in the preamble and certainly we do think there are some negative effects on ESOP participants and ESOP formation from the proposal we'd like to talk about.
And then, finally, we'd like to suggest some alternative approaches that might better achieve your goals and also promote ESOPs at the same time.
So in looking at the comment at the proposal it seems like there's three stated reasons for the proposal. First, that the market for retirement plans has changed over the years, in the last 30 years. Second that there's some conflicts of interest in the marketplace among service providers and then finally, third, that there's incorrect valuations that you're seeing of employer securities.
So with respect to the first point, there are, as other speakers have said, lots of changes in the marketplace. I'm not sure there's been that much change in the ESOP marketplace. The relationship of the trustee hiring an appraiser to perform an independent valuation is actually much the same today as it was back in the '70s when the regs were -- the rules were in place.
As far as conflicts of interest go, I mean, just in looking at our own membership and talking to folks, we're not seeing that appraisers are suffering from conflicts of interest with other parties to the transaction so definitely we could look for some more clarity from you guys on that.
I think where that leads us is to focus on the last point, which is incorrect valuations and that that's really the focus of the ESOP aspect of this.
The term "incorrect valuations" implies to us that there's sort of a mistakes being made, that there's a -- or that there's a right and wrong way to do appraisals and so some people are doing them the wrong way and some are doing them the right way. But, in fact, the appraisal really is much more of a professional opinion as to value and professional judgments involved. So I think once someone establishes they're following the Uniform Standards for Appraisals and they're an ASA or other -- meet other qualifications to perform appraisals, it may just be a matter of a difference of opinion of professional judgment as to whether an appraisal would be considered correct or not.
You know, for example, if you're -- I guess if you're looking at somebody who is just applying the book value method and no other method of valuing stock in an industry where that's clearly inappropriate that may be an incorrect appraisal. But I think a judgment call on what the multiples are, what the correct EBIDTA multiples are in an industry is much more of a professional judgment that we could disagree over.
So, I guess, that led us to speculate that, you know, perhaps you're seeing unprofessional appraisal reports and I guess we're wondering whether those are being performed by experienced and credentialed appraisers.
You know, as I said, in comparing some notes with other people in the Association, I think what we're seeing is that there has been a significant increase in Department of Labor investigations of ESOPs and a lot of looking at ESOP valuations, but I'm not really aware that there have been the investigations like that that have turned into litigation. And, in fact, a lot of those have been closed out where the Department has apparently found the valuation was perfectly fine.
So, let me turn to does the -- the question I had was: does the proposal really solve the problems that you've identified? I think that, again, if you -- if the problem is that it's an incorrect appraisal, meaning the appraiser doesn't understand valuation theory, if that's what we're getting at, I'm not sure that solves the problem.
One of the, I guess, ugliest things I think I've read in a case in a while was the Gutierrez case in the Ninth Circuit where the District Court really, you know, went on and on about the appraiser who was involved there. I think he either didn't have a high school diploma or didn't have a college degree, was a convicted felon who I think whose felony was related to a financial crime, which is terrible and I don't think any of us want to have those people appraising companies either.
But at the same time, I'm not sure making that guy a fiduciary would have changed the outcome there in terms of would that person have performed that appraisal and done it the way he did. I think maybe the problem there was the trustee fell down in its duties of not really carefully selecting the professional to provide that service. And so, I guess my contention would be I'm not sure making that guy a fiduciary would solve the problem.
In addition, and just looking at -- there's at least an implication I think in the proposal that over-valuations of stock may be a problem. And in thinking about that it seems like there's both overvaluations and under-valuations that can be a problem with ESOP's.
You've got transactions going on where an ESOP's the buyer and you wouldn't want to have the appraiser over valuing stock in those situations but, at the same time, with ongoing ESOPs that are just getting annual valuations where their benefit distributions are based on those -- the appraisal, if that's being over- valued the participants, of course, are getting more money than they should be getting. So, I think that's -- I'm not sure if we make people fiduciaries here, it perhaps leads to a more conservative approach by appraisers that you're not going to get the outcome you want either because I think then I'm not sure just conservative is the solution to the problem.
But, again, you know I think the ESOP Association and other speakers here from the appraisal community would love to have the chance to work with you guys to talk about maybe what -- you know -- what would work.
That clock's moving faster than I thought it would. Okay.
So next point I want to make is about -- does the proposal -- what does the proposal do to the appraisal and ESOP community and what are some of the problems that are caused? I guess I'd start by saying, others have said this yesterday, there is an increased cost to ESOP companies from the proposal and I think those costs take the form first in appraisers are going to need to buy fiduciary liability insurance.
Right now, I can't tell you how much that costs. Perhaps we can give you some data on that. But what the ESOP trustee community is facing right now is a situation where costs are increasing for their fiduciary liability insurance and, in fact, I think the market is beginning to shrink for that professional service because of the difficulty in finding adequate fiduciary liability insurance.
So I'd be concerned that appraisers are going to face the same marketplace when they go out to try to create this new product with their insurers of getting fiduciary liability insurance.
The second concern we have is that we may be driving the good people out of the marketplace and keeping the bad people who maybe are producing appraisals that you're seeing that are a problem.
And probably first on that list of concerns is that the folks who are working at multidisciplinary firms where there's investment banking services, there's M&A services, there's capital market services, those people tend to be a small percentage of that firm's gross revenues and we're afraid that what those firms will find is that it's not worth keeping those people around because of the additional fiduciary exposure that's being caused.
The third cost is, I think everybody who's at a risk of fiduciary, probably needs their own lawyer. So I think you'll find appraisers are going to have to hire their own law firm to represent them in each of these transactions, which adds another law firm to ESOP deals and increased costs.
I also, similarly, I think probably every lawsuit that gets filed against an ERISA -- excuse me, an ESOP fiduciary is going to name the appraiser as a defendant. And, in fact, I think if the case has pretty much anything to do with the trustee's actions, it's probably going to be malpractice for the plaintiff's firm not to name the appraiser as a defendant in the case.
And in thinking about how that might work, I mean, there may be ways to shape the fiduciary limits of the appraiser, but then I look at what courts have done with fiduciary rules and I think I'm not sure even if you try to come up with a rule today, you're going to save these appraisers from years of litigation trying to figure out what the standards are.
And, finally, I just think there's going to be some confusion between the role of the trustee and the role of the appraiser in trying to execute transactions where now the appraiser's providing a product, which is a valuation report, and the trustee goes out and makes decisions based on report, if, in fact, they're both fiduciaries it may be that there's not a clear decision-maker there because both parties will feel some fiduciary obligation to make things come out the way they think they should come out.
So, finally, just to mention some thoughts we had about alternatives, you know, first I think we had, as I suggested, I think dialoging with the appraisal community would be -- to talk a little further about the problems are would be a great idea.
Can I just take about thirty more seconds?
I think in terms of independence, if you look to the adequate consideration regulations, they almost defined independent appraiser for us. And I think if you took the opportunity to go back those, there's probably some relatively straightforward things you could put in there like do you think CPAs auditing the financials should or shouldn't be independent? Do you think somebody who's done estate planning for the shareholder -- other shareholders of the company and have delivered valuations, are they or are they not independent?
I mean, I think there are some rules that you could come up with there that would be relatively straightforward. And, similarly, I think in terms of accreditation, without creating a new Department of Labor system that has its own accreditation for appraisers, which would be way too complicated probably, I don't think you'd want to do it, there's a lot out there in terms of USPAP, the AICPA; there's a lot of standards to look to. I think you could just borrow those and graft them into the adequate consideration regulations to create a standard for accreditation.
Okay. I'm going to stop. Thank you very much. I apologize for going over my time.
Mr. Davis: Ms. Carlisle.
Ms. Carlisle: Good morning. My name is Linda Carlisle. I'm a partner at White and Case and have served as general counsel of the Employee-Owned SCorporations of America or ESCA since its creation.
ESCA is the national voice for S-corporations owned by ESOPs or Employee Stock Ownership Plans. ESCA's members include privately held ESOP-owned Scorporations and many professional firms that deal with the ESOP community.
ESCA, its member companies and their tens of thousands of employee owners appreciate the opportunity to speak with you this morning about these proposed regulations that would expand the types of advice and recommendations that constitute rendering investment advice for purposes of the definition of a fiduciary under ERISA.
In particular, the proposed regulation would make the provision of an appraisal or a fairness opinion to an ESOP concerning the value of securities or other properties investment advice with the result that the duties and liabilities of an ERISA fiduciary would be imposed on such person providing the appraisal or a fairness opinion.
As you know, ESOPs are required under 4975 of the Internal Revenue Code, to be designed primarily to invest in employer securities. Section 401(a)(28) of the Internal Revenue Code requires an ESOP to provide - - to obtain a valuation of such employer securities at least annually.
In addition, 4975 of the Code and 408(e) of ERISA provide that an ESOP may not purchase employer securities for more than adequate consideration, i.e., the fair market value of the employee securities as determined in good faith by the ESOP trustee or named fiduciary.
Since S-corporation stock is by definition not publicly traded, the ESOP trustee or the named ESOP fiduciary with respect to the ESOP, cannot rely on market prices or public quotations to determine the fair market value of the stock. Accordingly, such ESOP trustee or ERISA fiduciary generally engages an expert appraiser to give advice regarding the fair market value of the employer securities.
ESCA members, therefore, have a keen interest in the effects that the proposed regulation would have on the advisers who provide these annual appraisals to their S-corporation ESOPs.
As background, section 3(21)(a)(ii) of ERISA, as you all know, defines a fiduciary with respect to an employee benefit plan to include, "any person that renders investment advice for a fee or other compensation with respect to any monies or properties of such plan or has authority or responsibility to do so."
Regulations issued by the Department of Labor in 1975 further defined the circumstances under which a person is considered to render investment advice to an employee benefit plan within the meaning of ERISA.
Under the regulation, a person that does not have discretionary authority or control with respect to the purchase or sale of securities or other property, does not have discretionary control, would not be considered to be rendering investment advice -- or would be considered to be rendering investment advice, rather, only if the five following conditions are met:
Such person renders investment advice as to the value of the securities; such advice is rendered on a regular basis; such advice is rendered pursuant to a mutual understanding; such mutual arrangement will serve as the primary basis for acquiring the stock; and such mutual arrangement or understanding will be individualized based upon the particular needs of the plan.
Shortly after 1975, the Department of Labor addressed specifically the appraisal duties of a privately-owned S-corporation -- not S-corporation but ESOP company and issued an advisery opinion, which concluded that the valuation of closely held employer securities to be purchased by an ESOP, did not involve an opinion as to the relative merits of purchasing securities, but that would be relied upon and would not constitute investment advice.
That has been the law since 1976. Thus, pursuant to this advisery opinion, the DOL specifically considered whether a person who provides an ESOP with a valuation opinion with respect to closely held employer securities should be considered to be a fiduciary and determined that it should not.
The Department of Labor in the proposed regulations has stated in the Preamble why you think it is appropriate now to change the law that has existed for a couple of decades. The Preamble notes that a common ERISA violation is found to be in their -- in your enforcement initiative with respect to ESOPs' incorrect valuations of employer securities. And these cases include instances in which planned fiduciaries have reasonably relied on faulty valuations prepared by professional appraisers.
The Preamble states that the Department of Labor believes that broadening the definition of investment advice to include appraisals and fairness opinions may directly or indirectly address these enforcement issues and align the duties of such appraisals -- such appraisers with those of the plan fiduciaries.
The proposed regulations would expand the types of advice and recommendations that result in fiduciary status to include the provision of an appraiser for a fairness opinion.
This change would supercede the DOL's 1976 advisery opinion, thus fiduciary status would be imposed on all persons who provide an ESOP with an appraisal for the purchase of employer securities or with respect to its required annual valuation.
ESCA is concerned about the proposed regulation because it would in -- it results in a major expansion of the legal liability and increased costs of insurance for appraisers.
ESCA understands that for many top-tier appraisal firms, ESOP appraisals are not a major portion of the firm's business.
ESCA's concerned that such established and well-respected appraisal firms will choose to discontinue their ESOP appraisal work rather than face the additional legal exposure and insurance costs that come with fiduciary obligations. Removing the most experienced and competent ESOP appraisers for the ESOP appraisal market will force many ESOPs to use smaller and less experienced appraisers who may not be able to provide superior service and necessary ESOP expertise.
In addition, increased insurance costs that ESOP appraisers will incur will be passed on to the ESOP.
ESCA's concerned that such increased costs will diminish the retirement savings of the Scorporation ESOP participants and may discourage the formation of S-corporation ESOPs.
Thus, ESCA's concerned that expanding the definition will not improve the quality of appraisals but rather will have the perverse effect of reducing the number of competent appraisers available to make such valuations and would significantly increase ESOPs' cost of obtaining the necessary advice.
Comments with respect to the proposed regulations have suggested alternative approaches to the problem. ESCA has not endorsed any specific alternative approach but urges the Department of Labor to consider alternative means of ensuring correct valuations. Among the alternatives suggested and other comments it is that regulations provide more specific guidance to ESOP fiduciaries regarding their duties to correctly value employer securities.
The DOL proposed regulations issued in 1988 that remain in proposed form set forth guidance regarding how ESOP fiduciaries should determine fair market value of closely held employer securities to ensure that such valuations are good faith determinations of fair market value.
The Department of Labor, however, has never finalized those regulations and guidance issued by the Department of Labor in final regulations at this time need not be limited to the guidance in the '88 regs and could provide specific guidance regarding the necessary expertise, training or experience providing valuation opinions to an ESOP.
My last sentence. It has been 35 years since the Department of Labor first issued the regulations that govern the types of investment advice relationships that give rise to fiduciary duties. Given the potential problems raised by the proposed regulations with respect to privately owned ESOP companies, ESCA respectfully requests that the Department of Labor not adopt the proposed regulation until it has thoroughly considered other ways to ensure that ESOP-owned S-corporations receive reliable appraisals.
Thank you for your time.
Mr. Davis: Thank you, Ms. Carlisle.
Mr. Reilly: Good morning. Good morning, my name is Robert Reilly. And let me commit that I will not take all ten minutes to read my statement.
Ms. Carlisle: I only took thirty seconds more.
Mr. Reilly: It's like the Academy Awards.
When I'm not volunteering for the AICPA, I do work for a valuation firm. In fact, I've worked in the valuation profession since 1976. I performed my first valuation of an ESOP-sponsored company in 1981, so I've been performing such valuations for 30 years. And over that 30-year period, I've performed hundreds of valuations of employee benefit plan sponsored companies. I'm involved in dozens of such valuations each year and I've testified on numerous occasions in Federal court with regard to the quality of ESOPrelated sponsored company valuations.
And I was asked to say that by the AICPA just to give my reason for being the member of the committee who was asked to be here today. But today I am here representing the American Institute of Certified Public Accountants or the AICPA, and specifically the Forensic and Valuation Services Executive Committee, the FVSEC.
Thank you for the opportunity to present our views on the Department's proposed rule that redefines the circumstances under which a person is considered to be a fiduciary under ERISA by reasons of providing advice to the employee benefit plan or to a plan participant.
The proposal specifically includes the preparation of appraisals in connection with plan transactions related to the value of securities or other property.
The AICPA is the national professional membership association of over 360,000 certified public accountants. The AICPA has a forensic and valuation services section for CPAs that perform business valuation services and the AICPA administers the Accredited in Business Valuation or ABV credentialed program.
ABV credential holders must hold a valid CPA certificate, pass a rigorous examination, have a significant amount of business valuation experience and maintain continuing professional education requirements.
ABV credential holders are committed to continuously improving their valuation skills and expertise resulting in increased professional competency.
Many CPAs perform business valuation services. Many of these CPAs regularly value the stock of employer corporations that sponsor an employee stock ownership plan, an ESOP, or other employee benefit plan. These employer stock evaluations are typically performed for transaction, taxation or plan administration purposes.
We commend the Department on its concern and diligence relating to the quality of employee benefit plan sponsor company valuations. The issue of the quality of sponsor company valuations is real and it affects plan participants. Substandard valuations of the sponsor company may cause the associated benefit plan to make an incorrect investment decision if the sponsor company stock was improperly valued at the time that the benefit plan purchases the employer securities.
If the employer stock valuation is too high, then the plan participants would earn a decreased rate of return on their investment.
We firmly believe, however, that treating the sponsor company valuation analyst as a plan fiduciary is exactly the wrong way to address this issue. In fact, defining the valuation analyst as a fiduciary will be disadvantageous to benefit plan participants for several reasons.
Let me take a few minutes to summarize our concerns as discussed in our comment letter, then I will spend the remainder of my time discussing what we believe is the appropriate and cost-effective solution to the problem of substandard valuations.
As stated in our formal comment letter to the Department, we have four significant concerns with the proposed change:
One, the proposed change, the definition is incompatible with the Internal Revenue Service regulations for an independent appraisal of employer securities.
Two, the proposed change does not address the underlying issue of proper qualifications and professional standards for performing valuation services.
Three, the proposed change will increase the cost of valuation services for ESOP and other benefit plans and,
Four, the proposed change will restrict the number of valuation specialists willing to perform sponsor company valuations for ESOP and other benefit plans.
First, the conflict with the IRS requirements for independence is a real and significant issue. As a fiduciary, a valuation analyst would have to perform the valuation in a manner that is in the best interest of the plan participants; whereas, the IRS requirements require the valuations be performed such that the value is the most correct value without regard to the impact of that value on the end user.
Second, holding valuation preparers to the standard of a fiduciary would open the door to increased litigation, which in turn significantly increases the cost of insurance for valuation analysts if they can get such insurance at all.
Third, many of the most reputable and wellestablished firms would likely stop offering valuation services for employee benefit plans due to the increased risk driving the very professionals who are best suited to prepare such valuations away from this work.
And, fourth, for firms that continue to offer these valuation services, the increased cost would be passed on to the plan participants through higher plan administration costs or decreased earnings of the sponsor company.
So what is the solution? The sponsor company appraisals should be performed by a qualified individual in accordance with valuation standards. We believe a qualified appraiser should have proper credentials that demonstrate the individual has the education and experience to perform sponsor company stock valuations.
We recommend that the Department require all sponsor company valuations to be performed by professionally credentialed valuation analysts. Those valuation analysts would be required to prepare the valuation in compliance with generally accepted business valuation standards similar to those standards encompassed by Internal Revenue Code section 170(f)(11)(e) related to qualified appraisers.
Those standards include minimum education, experience, and licensure or certification requirements.
We recommend that the Department establish similar minimum qualification requirements for employer stock valuations. If the Department would require similar requirements for the preparation of valuations for employer benefit plans, then the risk of a plan receiving a low quality appraisal would be substantially mitigated.
The AICPA issued Statement on Standards for Valuation Services No. 1 or SSVS-1 in June of 2007. SSVS-1 established standards for AICPA members who are ownership engaged to estimate the value of a business, business interest, security or intangible asset.
Since SSVS-1 was issued, all other domestic valuation organizations have changed their valuation standards so they are professionally equivalent. These
SSVS-1 standards outline minimum requirements for:
One, the development of an opinion of value; and two, the reporting of that opinion.
We believe the AICPA professional credentials and professional standards meet the current valuation and analyst requirements of the Internal Revenue Code. In contrast, the definition of the sponsor company valuation analyst as a fiduciary is fundamentally in conflict with the independence requirements for valuation analysts as presented in the Internal Revenue Code.
Again, thank you for your time and interest today. I would be happy to answer any questions.
Ms. Borzi: Okay. Let me start with this last point that you made because it -- every time I've seen it throughout the comments and I -- I just don't get it, how the Code standard that you have to provide the most -- the independent standard and the most correct standard is fundamentally incompatible with the fiduciary standard.
In the fiduciary -- the fact that you perform activities in the best interest of participant and beneficiaries doesn't mean you put your finger on the scale in their favor. Both of these standards ask the person doing the valuation to do -- to provide the most correct, in the words of the Code, valuation.
I just -- please help me, because I don't seem to be able to reconcile the fact that you all have -- that you have said here and many of the commenters have said in their comments that these are irreconcilable standards and I really don't get it. So could you help me out here?
Mr. Reilly: Sure. Let me answer first and the other panelists may want to answer as well.
I would agree if valuation was a science like measuring chemicals in a laboratory or even something as simple as telling time where you could look at a watch an everyone in this room could agree that that number is 29 minutes right now.
Then, there should be no difference between being a fiduciary and being independent. I personally believe, and I believe the AICPA would -- I'm saying this for the AICPA as well. The problem is is a lot of judgment in evaluation. There is always a reasonable range within all approaches that we use, within all methods that we use, within all the procedures, within methods, within approaches.
If I'm totally independent I want to go right down the middle, and if anything be maybe slightly conservative with regard to the valuation. But really, I want to go right down the middle every time a judgment has to be called in selecting procedures, methods and approaches or -- and the other way around, approaches first, methods and procedures and in quantifying the valuation variables that go into each of these.
If I'm a fiduciary, however, I can't ignore that within my reasonable range; that would be professionally supportable and I'd be willing to testify to, would be absolutely professionally supportable if I know it's in the best interest of my client to have a range -- to have a conclusion that's slightly to the right of center or slightly to the left of center. And I could just as easily justify right as left, frankly, I'm going to select right.
Ms. Borzi: But that's not -- that -- I guess I still don't understand because, again, the fiduciary standard as interpreted by the Department and by the courts is not that you ignore everything else and single-mindedly put your finger on the scale so you do -- I mean, so that you do the best interest of the participants.
If that was -- if that were true, there wouldn't be any instance in which you could actually fairly balance the interest of the participants and the other people involved and that's not the way the fiduciary rules work.
I really, honestly do not see the incompatibility here. Do you have to be careful? Yeah. But, you know, that's what the fiduciary standard demands of everybody that they be careful. So, you know, anyway, I don't see this argument and --
Mr. Reilly: I see what you're saying, ma'am, but I --
Ms. Borzi: I mean, I can see why you're afraid but that's what every -- every fiduciary, the point of the fiduciary rules is that you have to be careful.
Mr. Reilly: I agree. And let me say this. I don't believe -- again, we all have our own personal opinion. I don't believe it's putting your finger on the scale. I believe the scale has --
Ms. Borzi: I don't either. I think that's what the fiduciary rules say you can't do.
Mr. Reilly: But I don't think that's what I'm suggesting.
Ms. Borzi: Yeah.
Mr. Reilly: I'm suggesting that the valuation scale says anything between 10 pounds and 11 pounds is equally legitimate.
Ms. Borzi: And I don't think anybody, certainly nobody here at the Department is going to waste resources going after somebody who gives a valuation that's within the reasonable range.
But if you look at the reported cases, one of my criticisms of the Department when I was in the private sector is they only took the safe cases. They only took the cases in which no reasonable person in America could think, like the case you cited, that that person gave an evaluation that was consistent with anything, professional standards or not.
So I don't think that the record that the Department has shows that it's going to go after people who make valuations when there's a reasonable range.
But I want to move on to another question because I don't want to take all the time.
The other thing that I noticed about all three of you is that you seem to assume that if the valuator -- if the person making the valuation comes from a large well-respected entity that somehow the quality of all those valuations is without reproach.
And, similarly, you make the point that the most important thing is credentials, you know, how well credentialed people are. Well, again, if you look back at the cases that have been reported and the investigations that the Department has done, what you see is improper valuations are not limited to the small fly-by-night valuation companies. Some of the people that the Department has sued are large well-respected firms. And I don't want to cast dispersion on the firm or firms but I don't -- I don't understand your assumption that because somebody works at a large firm that therefore, they are beyond reproach.
Ms. Carlisle: Do you want to do that first or --
Ms. Borzi: So can you --
Ms. Carlisle: I'll be happy to. And, first off, we did -- I did not mean to imply that large firm versus small firm means good versus evil. What I did mean to suggest is that in a large firm that has a big valuation practice if a small portion of that practice is geared towards ESOP valuations that firm, which by definition has a large client base, has large -- a large number of employees in the profession, will shy away, may shy away, from doing ESOP appraisals in the future. Okay.
I am saying that that firm may, as Robert said a few moments ago, have people that are well versed in determining the appropriate range of appraisals just because they do it for a lot of people. Does that mean that a small firm can't do that? Of course, not. Okay. I as well as you know many excellent professionals in small firms and large firms. It wasn't generalization but it was meant to point out that we are afraid that we will lose that pocket of expertise. Not the only pocket but that pocket of expertise that resides in the big firms.
Did that help?
Ms. Borzi: And finally, I have a request for all three of you, because all three of you mentioned in some way that an alternative you would suggest that the Department pursue is to look -- look to revitalize, if you will, or re-examine the adequate consideration proposed reg.
So here's my request. If you could submit for the record some suggestions that you would have of very specific things that given what the proposed regulation was that you think might be helpful if we were to re-examine that to add to that regulation to solve these problems. So that would just be my request.
And thank you very much for your testimony.
Mr. Goldberg: You know what, one thing I would add on the big versus little.
Ms. Borzi: Sure.
Mr. Goldberg: I would agree with the comment that I also did not mean to imply you guys have an easy of just drawing a line --
Ms. Borzi: And because some of the people we have sued have --
Mr. Goldberg: -- small is bad is good.
Ms. Borzi: -- a million credentials.
Ms. Carlisle: I agree.
Ms. Borzi: The highest credentials that would be. And that that -- that isn't sufficient is what I'm suggesting.
Mr. Goldberg: Yeah, one thing that I think the Association wanted to point out is what gets lost, I think, in the community if those firms stop doing ESOPs it's because they are engaged in lots of different kinds of financial advisery services, that I think just add to the knowledge pie of this world of the ESOP community, I think, removing those investment bankers and capital markets people out of the ESOP advisery community is just kind of a loss to the knowledge base.
Ms. Borzi: I hear you.
Ms. Carlisle: Yes.
Mr. Reilly: And that was the same -- I don't mean to -- but I think this would be of interest to everyone on the panel if I may. I think that's -- the small versus large is not a quality it's how much can you afford? If you work for a small firm and I'd have to say, my firm is a small firm, so I don't want to say that's low quality. We can --
Ms. Borzi: But I know some expensive small firms.
Mr. Reilly: But not only -- well, I think we are an expensive small firm.
But the question is: Can a small firm afford the cost of insurance to be a fiduciary? A large firm may be able to, they have hundreds of millions of dollars of revenue a year. A small firm may not simply be able to afford the cost of the insurance.
And with regard to credentials versus standards, and this is something -- and I'm saying this as a CPA and I know the AICPA staff members will probably throw tomatoes at me when I say this, but it's not a credentials issue in my opinion. It's not the letters after your name. The only thing you get with the letters after your name is the requirement to comply with standards. Anyone who complies with standards, whether they're AICPA or ASA or IBA or USPAP, if you had a rule that the valuation analyst should comply with one or more of these standards I think that solves the problems. The only thing the initials buy you is if I'm a CPA I have to comply with those standards. I'm also an ASA, I have to comply with those standards. I'm also a CBA, so I have to comply with the Institute of Business Appraiser standards because I'm required to.
Someone who doesn't have those initials but still complies with the standards, you get the same quality.
Ms. Borzi: I mean, as you know, we do a lot of work with the AICPA and the discussion for another day is of what real teeth -- what real teeth these have -- these standards have, what kind of enforcement. That's not the issue today.
So let me just turn it over to Michael.
Mr. Davis: Yeah, and I wanted to ask about this cost issue, the fiduciary insurance issue which you just brought up, Mr. Reilly. And I would ask this of all the panel.
You all testified that you're concerned about the availability of fiduciary insurance, the cost of that insurance. Can you be more specific? I think, Mr. Goldberg, you said you don't have that data with you but you could send it forward maybe for the record.
But if you guys could give us a better sense of now, who are the providers? How much does it cost? How is it priced? Is there really an issue with capacity in the marketplace today and are you concerned that if this reg goes forward as proposed, that there wouldn't be adequate capacity to really cover the entirety of the marketplace? Can you be more specific?
Mr. Reilly: I don't have the numbers, but I could provide them as well.
I can say this from my own personal experience. The company I work for is called Willamette Management Associates. It's a funny sounding name, but many years ago, Willamette valuation -- Willamette Management Associates was a registered investment adviser where in addition to performing valuation services, we actually gave investment advice. We couldn't afford to continue doing that. The insurance was just too expensive.
As a regional firm, we only have three offices, as a small, small firm, we simply couldn't afford to continue operating, giving investment advice because we needed to have the fiduciary insurance to be a registered investment adviser. We just had to drop that line of business and focus entirely on business valuation services.
Every year, the cost was expensive. And that was the decision we made 20 years ago. Now, I've got to believe the cost of insurance is a lot higher today than it was then.
We could all find, I'm sure, current price quotes for you but it was a very expensive proposition for us.
Mr. Goldberg: I would just add, again, I don't have the numbers but I think just to benchmark it a little bit, when I see clients buying fiduciary liability insurance for their company and their transactions, the premiums they're paying on an annual basis probably look like -- they're probably actually somewhat similar to the cost of getting an appraisal done if not a little bit more than larger companies.
So if a company is spending $20,000 to get an appraisal done it wouldn't surprise me to find that the insurance premium that company's paying for fiduciary liability insurance right now is on the order of 20 to $40,000 as a premium. So it's not a perfect example but if you graft it on the fiduciary exposure, the insurance company's taking in that policy and saying I'm going to provide this to an appraisal firm, you know, that might be a benchmark to look at.
But I do think that, you know, the appraisal community perhaps can come up with better data to give you on it.
Mr. Davis: And is that fiduciary insurance provider marketplace a fairly diffuse set of providers or is it just a few who sort of dominate the market and sort of have a lot of control over --
Mr. Goldberg: Few who dominate the market.
Mr. Davis: Is that right?
Mr. Goldberg: I would -- would you --
Mr. Reilly: That was exactly our experience.
Ms. Carlisle: Yeah.
Mr. Reilly: We went through an insurance broker and we received a quote from two or three companies every year and we understood that was basically -- those were the players.
Ms. Carlisle: But I understand you're asking for more than anecdotal?
Mr. Davis: Right.
Ms. Carlisle: If we can provide it.
Mr. Davis: That would be great.
Ms. Carlisle: Yeah, and we -- all I can give you is anecdotal and we'll see what we can do to provide you with.
Mr. Davis: That would be great.
And, Mr. Goldberg, I just had a question. I'm just really excited that the Association's testifying. But I did want to understand better the Association itself.
It represents both corporations and there's a second there professional membership for service providers?
Mr. Goldberg: Right.
Mr. Davis: Are there circumstances that may land differently for those two classes of groups that - - for which their interest may diverge?
Mr. Goldberg: Between service providers and companies?
Mr. Davis: That's right.
Mr. Goldberg: Sure. Yeah. I think that's right. I mean, the -- you know, the company members -- the organization is really -- I guess I would describe it this way. The organization is really a company-dominated organization. It exists for the benefit of the companies that have ESOPs. And I can tell you as a service provider our expectation is we're supposed to donate lots of free time helping stock companies and volunteer our services.
So I think -- but if you -- you know, if you looked at the -- for example, the impact of this, I mean, I think increasing the cost to ESOP companies of having an ESOP might cause ESOP companies to either abandon their ESOP or companies that don't have an ESOP to not have one. That's an impact.
But on the service provider side, you know, I think there are some service providers who may look at this and say, you know, the best thing that could happen here is you guys drive out of business three or four of my biggest competitors and I'm a member of the ESOP Association and that's probably not a bad outcome for me from a business standpoint.
So, I think there could be some mixed, you know, interest among the service providers of the ESOP Association. But really in giving our comments, I think what's most constructive for you guys and what we're trying to convey is really what the company members who have employee ownership are looking at.
Mr. Davis: That's great. Thank you so much.
Ms. Carlisle: Well, let me -- let me also just mention, because ESCA also has service providers and member companies.
ESCA is primarily though a member company organization. So the comments are taking into account the views of our advisers but it is truly focusing on the impact to the S-corporation ESOP --
Mr. Davis: Okay.
Ms. Carlisle: -- company.
Mr. Davis: Thank you very much.
Ms. Carlisle: Thank you.
Mr. Lebowitz: So it seems to me that we have, I think, a consensus that there's a problem in the -- with valuations in the context of ESOPs. We certainly think there's a problem. And as someone who has some responsibility for an enforcement program, you know, I kind of see that problem almost everyday.
And the frustrating part I think I can represent from our point of view of our investigators and our enforcement people is that what we see is that the individual who who's at the center of the transaction is essentially unreachable under the current rules in any enforcement legal process.
And all that means is that everybody else has more responsibility, more liability, but ultimately the loss may fall on the participants themselves because we can't reach the person who was really -- who, as I said and I think you would agree, is at the center of the transaction, the person whose expertise is essential to a determination of how much the plan's going to pay for these assets.
And, you know, I think any solution to the problem has to be -- has to take that into account that there's a -- it's a situation that cries out for some kind of resolution. And I'm not sure that, you know, as Phyllis was saying, adding requirements for credentials in the absence of any kind of effective mechanism for enforcing those credentials, we could put credentials in a regulation, but if there's no sanction for not requiring -- for not meeting those standards, what's the point?
We already have a situation in the auditing area where a plan administrator is required to hire an auditor to perform an audit on behalf of participants and beneficiaries. If the auditor performs a substandard audit who gets penalized? It's not the auditor under our statute, it's the plan -- it's the plan basically, it's the plan administrator. I don't think we need another one -- another odd provision like that.
So, I mean, that's -- those are more observations than questions, I guess. But, let me ask Mr. Reilly, tell me what the role of the plan's auditor is in transaction -- in conducting an audit in the context of an ESOP, and specifically, with regard to the valuation. Does the auditor have any responsibility for determining whether it's a reasonable audit? I mean, what is the -- just what are they supposed to do, because they're ultimately going to issue an opinion?
Mr. Reilly: Surely. But, remember, there are two really fundamentally different opinions. There's the audit opinion prepared by the CPA and the valuation opinion.
Mr. Lebowitz: And I'm talking about the auditor's opinion.
Mr. Reilly: Okay.
Mr. Lebowitz: And I'm talking about the auditor's opinion. The auditor is going to render an opinion for the plan.
Mr. Reilly: Sure.
Mr. Lebowitz: About the financial statements that the plan has issued.
Mr. Reilly: Surely. In that case, and again, I'm a valuation guy. It's been over 30 years since I was an audit guy for a few years. But the auditors do have to comply with auditing standards. So they do have to comply with the SASs, the Statements of Auditing Standards in auditing any entity including an employee benefit plan. And if there are valuation aspects to the financial statements as their would be in fair value accounting in certain corporations or in this case, the value of the employer securities, they do have to comply with the SAS requirements for performing due diligence procedures with regard to the valuation.
That doesn't mean they recreate the valuation, they don't --
Mr. Lebowitz: Well, what does it mean? That's my question, what does it mean? What -- just what does the auditor pass -- does the auditor pass judgment? Does the auditor have a responsibility to say this looks -- this doesn't look right, I'm going to issue -- I'm not going to issue an opinion or I'm going to issue an adverse opinion or a qualified opinion? Just -- I've never really understood this in all the years I've been trying to figure out the role of -- you know, just what the significance of an audit opinion is.
Mr. Reilly: Well, I'm going to have to pass, because I personally have never performed an audit of a pension plan or ESOP.
Mr. Lebowitz: I would --
Mr. Reilly: I can find out for you and get you a written answer.
Mr. Lebowitz: Well, I see there are others here from the AICPA, but I would -- I would ask that the AICPA, for the record, give us their understanding of what the auditor's role is in the context of an ESOP, typical ESOP transaction and just -- and specifically, with regard to the valuation that's prepared.
Mr. Reilly: I can answer though from the other side, again, being participating in really a couple of hundred valuations over the years. We rarely, if ever, communicate with the auditors. We may occasionally seek questions --
Mr. Lebowitz: That doesn't surprise me, frankly.
Ms. Borzi: Therein lies the problem.
Mr. Lebowitz: I think that's entirely consistent with our sense of things that the auditors really don't spend a lot of time assessing the quality of the valuation. And -- but I -- I don't want to get into an area that you're not in a position to --
Mr. Goldberg: Can I just add a little bit of color to that. I do have an accounting degree, although I'm not a licensed CPA.
So the accounting profession did come out with guidelines that -- a while back that have caused not only plan auditors but maybe more importantly, the auditor of the company's financial statements to be obligated to look at the ESOP valuation and test the reasonableness of the ESOP valuation.
And I can tell you from experience, the AICPA could comment better than I can. But our clients who have -- I'm sorry, I'm speaking on behalf of ESOP Association and these are our members. They -- you know, their experience I think now is that they are turning over their valuation reports to their auditors of their companies' financial statements because they're being required by AICPA to test the reasonableness of that. And there have been instances I know of that where there's been heated discussions between the ESOP valuation firm and the companies' auditors to really get to the assumptions being made and the report and, you know.
So I would say, since I think this is, you know, a relatively recent development that is on the company side, there's probably more that will develop from this. But right now I think the start we're off to is that accountants are looking very hard at these ESOP valuations.
Mr. Reilly: Well, I do know that's true. We do have to submit either through the company or directly to the audit firm, our valuations to the accountants. It may be that we do a decent job because we don't get a lot of questions back. But we do submit our valuations to the accounting firm either directly or through the --
Mr. Lebowitz: Well, again, in the nature of an observation, in each one of our cases in our investigations there's an audit and even in the most egregious situation some auditor has said this is -- didn't say anything about the quality of the valuation.
There are other problems that exist in our statute in terms of being able to bring any effective sanction against the auditor in that circumstance. But the point I'm making is that there are auditors and we do wonder what their -- what their role is in this. And they are supposed to be the -- a safeguard here and it's hard to -- it's hard to know exactly how that process is supposed to work.
The only other observations -- I'm making a bunch of observations this morning. It did occur to me yesterday actually listening to many of the witnesses and then hearing you this morning, talking about the possibility at least that people will decide if we do what we've proposed to do. Valuation firms may decide to withdraw from the ESOP market.
I've been around for a while and it -- I don't know that I could count up -- there's a number high enough of the times that I've heard various -- various parts of the employee benefit service provider community say, "If you do this, we're not going to provide services to plans anymore." I'm amazed that there's anybody out there who provides any service to any employee benefit plan, because we've actually done some of those things and, yet, they're still there. But, anyhow.
Mr. Goldberg: I'll give you one example of that, ESOP trustees. I do agree with your comment, but if you look at the marketplace for ESOP trustees today, it's very different than it was several years ago. And I think that a lot of firms that were in the business got sued. And even when they won lawsuits, what they found was the insurance costs and the costs of just being in the business was just --
Mr. Lebowitz: Well, let me -- I don't want to --
Mr. Goldberg: -- too high to make a profit.
Mr. Lebowitz: -- take too long but let me just -- do you think that might change if the person who's at the center of this transaction, the valuator might have some culpability, might share in the liability for doing it -- for doing an improper valuation?
Mr. Goldberg: In that people won't sue the trustee but they'll sue the fiduciary?
Ms. Carlisle: They'll sue everybody.
Mr. Lebowitz: It could be somebody else.
Ms. Carlisle: They'll sue everybody. It's joint and several liability.
But could I make some observations on your observations?
Mr. Lebowitz: It's to share it a little more equitably, don't you think?
Ms. Carlisle: One observation that you made is that we all -- there is a consensus that there are problems with ESOP valuations. I mean, I'm not sure that that consensus is shared by the private sector. Okay. To the extent we understand that there are problems with the ESOP valuations, we will do everything we can to address those, but I'm just noting that I'm not sure that there is a private sector as well as public sector consensus there.
When you say the center of it all is the appraisal, the trustee or the ESOP fiduciary is the person who has to accept the appraiser. Okay? Has to get the appraisal. To me, they are at the center of the transaction and they are definitely fiduciaries.
So those are just my -- oh, and with respect to services, the other, I agree with you. The sky is always falling and people are always leaving. But I am -- but it is true that costs will go up and they will impact the benefits to ESOP participants and that's what we are concerned about.
Mr. Hauser: Mr. Goldberg, based on your experience in the industry, do you think that plan fiduciaries generally when they seek an appraisal, are looking for the most correct opinion as to value or do you think they're slanted, they're looking for a slanted opinion?
Mr. Goldberg: Well, I'd say my short answer is I think they're looking for the most correct --
Mr. Hauser: And do you think they breach their fiduciary obligations by asking for the most correct opinion?
Mr. Goldberg: No. No, I don't.
Mr. Hauser: So do you think then that the fiduciary duty of loyalty in the case of these fiduciaries requires them to do anything other than get the most accurate information about what the valuation is so they can act in an informed manner?
Mr. Goldberg: Yeah. Actually -- well, it would, because I think once they've contracted to get this valuation and they've seen the price or more often a range of prices, I think the duty of loyalty really kicks in in terms of executing their fiduciary responsibilities as a trustee to decide what do I do with this work product? Am I doing benefit distributions and taking into account a lot of factors about the ongoing company and I'm looking at it through that lens or a transaction.
So I guess I would say the loyalty -- I would say is exercised by the trustee.
Mr. Hauser: I agree completely with that. So, Mr. Reilly, when you're doing -- you've heard Mr. Goldberg testify. I mean, don't you think that you're not doing any favors to the fiduciaries if you slant the opinion in any way? I mean, isn't the best thing you can do for the plan and the fiduciary is just to give an honest rendering of what you think the best value is, including the best range of values and then let them go execute on it?
Mr. Reilly: Under the current definition of a fiduciary where the valuation analyst is not the fiduciary, I would agree with that entirely.
Mr. Hauser: No, but the guy asking you the question and looking for the valuation, he is a fiduciary and I don't think he has any duty to look for a slanted appraisal. So why would you have a duty to slant the appraisal if you became the fiduciary?
Mr. Reilly: Well, while he doesn't have a duty to ask for a slanted appraisal and I'm not suggesting that personally I want to give a slanted appraisal --
Mr. Hauser: I don't think so.
Mr. Reilly: -- he does have a duty to try to get the lowest price if the ESOP is buying the stock and to get the highest price if the ESOP is selling the stock.
Mr. Hauser: Right. But that's his job in executing the -- you know, doing the negotiations, doing the transactional work on behalf of the ESOP. And in actually executing his fiduciary responsibilities isn't it best that he just know what your best estimate of what the real value is so he can make sensible decisions about what the right point to sell at and what the right point to buy is?
Mr. Reilly: Again, if he is a fiduciary and I am not, I would agree. If we are both fiduciaries or I'm a fiduciary, now it's my obligation to help the ESOP buy at the lowest price and sell at the highest price.
So if I can otherwise present a range of values but it's now time for the ESOP to sell out to a corporate acquirer, let's say, I don't have to present the entire range. I can present the top half of that range. Now, that's still within my range but I am -- and I'm not saying that's again my finger is on the scale, because I feel very comfortable with that range but I'm trying to then as a fiduciary help my client, the ESOP, sell its -- the employer's stock for the highest price it can get when it wants to sell.
Mr. Hauser: Will that anxiety go away if we make it clear in our regulation or in the Preamble that that's just not your duty with respect to the plan even if you're a fiduciary?
Mr. Reilly: That would go a long way, yes, sir.
Mr. Hauser: Okay. And I guess going to this range point, most -- I've done a fair amount of ESOP work and most of the valuations I've seen -- and valuation work. Most of the valuations I've seen present a range. I mean, so it is -- when you're talking about, you know, kind of where within the range your price should be, are you suggesting that you would actually give a different range depending on whose side of the transaction you were or just at kind of the strike point or what have you for the fiduciary, you know, might be in a different point within that range? Or what are you saying?
Mr. Reilly: Well, again, if I was a trustee, I'm not suggesting I would give a different range. The range wouldn't go from $8 a share -- let's say $20 a share to $24 a share. I wouldn't move it then to $26 to 30. If the range is 20 to 24, I may present 22 to 24. That's still within my reasonable range of values. I'm not going outside the range, I'm not moving the range over. I may be presenting the range that would help my client buy at the low price and sell at the high price as long as I'm still professionally comfortable that I'm within my range.
Mr. Hauser: As you understand it, and really for anyone on the panel, is there currently a set of non-ERISA state law or other obligations that, you know, require that the valuation firm render its opinion in accordance with professional standards that they rendered impartially and that would give injured parties a means of obtaining a remedy in the event that you didn't meet those standards?
Mr. Reilly: Well, I won't -- let me just give my answer and then you'll get the legal answer from the lawyers.
But I did mention that I have testified a number of times in what I call and this isn't the correct title, the "failed ESOP cases." And in those cases, either what's happened is the ESOP participants believed that they paid too much years down the road and the plan itself sues a number parties, including the valuation analyst. Or, in other cases, the selling stockholders think that they received too little for the sale of their stock and they sue the valuation analyst and the charge there's not -- so I don't know if you all could bring this suit, because it's not an ERISA violation, it's a gross negligence violation.
You were simply negligent or grossly negligent. You recommended 20 to $24. It really should have been $10 or it should have been $30, but I've testified either in defense of the valuation analyst or as an expert witness against the valuation analyst in probably a good handful of cases -- two handfuls of cases related to these types of plan participants as the plaintiff or selling shareholders as the plaintiff where numerous parties could be the defendant, the lawyers, the fiduciary, but the valuation analyst is always named as a defendant in those cases.
Mr. Hauser: But to what extent do your clients think you're standing behind these valuations and accountable for them? How clear are you about the limit being gross negligence or negligence, or what exactly is your sense of what your clients understand your accountability to be for the valuations you render under current law?
Mr. Reilly: Well, I personally -- again, this is not a legal opinion, so only as the valuation analyst to the fiduciary, our client, or in some cases, our client is a selling stockholder, you know, working that side of the transaction.
I believe our clients think we are responsible for the valuation and we should be held accountable for the valuation and if there's reasons to think after the fact that they bought the stock for $20 based on our valuation when the real value was $30, well, if they -- that would be the seller being -- complaining about that. But if they bought the stock for $20 when the real value was $10, I would think that we would be named.
In fact, there was a case when we were named. We were a defendant in a case, it was dismissed but we were named as a defendant in a case where an ESOP said we paid too much because we relied on a Willamette valuation and after a lot of discovery it was dismissed. But we were named and we incurred a lot of legal fees for a company our size, you know, a lot of legal fees defending ourselves.
Mr. Hauser: Did you have an insurance carrier for that?
Mr. Reilly: We had an insurance carrier who picked up a portion of the expense but we still had our own deductibles and other expenses I think didn't cover it.
And we had to hire other valuation analysts to come in and support our work and attorneys and go through depositions and all of that.
Mr. Goldberg: You know, if I can just add one other thought to that, because I think maybe the Association might disagree with one comment Robert made.
In terms of --
Mr. Davis: Could you speak into the mike?
Mr. Goldberg: Yeah.
In terms of trying to define the scope of the fiduciary, I think, you know, sitting here today, I think a group of ERISA lawyers could try to draft a definition very tightly of what this valuation fiduciary is that attempts to address some of these concerns.
But I think that what seems open-ended to me at least, is that when you then toss that out to the plaintiff's bar to litigate and figure, number one, they're going to name appraisers as defendants in every lawsuit that gets filed. And, number two, that will give the courts the chance to sort of shape what these narrowly defined terms are.
I'm just afraid what will happen is I'm a fiduciary, I've produced this report, people have gone off and used it to do things and yet I have no ERISA fiduciary responsibility apart from defending the correctness of the report. I just think the opportunity is there for courts to really put a lot more at my doorstep as an ERISA fiduciary for things the trustee has done with my report and the analysis it's gotten.
You know, and fiduciary litigation can, you know, go out of control as we've all seen.
Mr. Piacentini: Good morning.
Ms. Borzi: Good morning.
Mr. Piacentini: So I think I heard, at least from Mr. Reilly and maybe from others that there can be a difference in different valuations in terms of where you come out in the range. Pardon me. Where you bound the range, because there is some judgment inherent in any valuation and sort of depending on whose behalf you're working and so forth.
So, and we talked a little bit about -- you know, had some debate, I guess, about how that might or might not work if you're a fiduciary.
How does it work now? Where does the valuation, you know, sort of move and because of, you know, what -- because of on whose behalf you're preparing it?
Mr. Reilly: Well, let me answer it first as the valuation guy. I would say right now without -- because we, or our fiduciaries, we can put the valuation right down the middle of the road, put the range right down the middle of the road whether I'm working for the selling stockholder or whether I'm working for the plan participants, whether it's a buy side transaction or sell side transaction or just an annual administrative allocation, I can put the range right down the road and not have to worry about who I'm working for because I don't have the obligation to help my client get the best deal that they can get.
Mr. Piacentini: And the client is the trustee?
Mr. Reilly: If we're working for the -- ESOP would be the trustee, yes, sir.
Mr. Piacentini: And the trustee is sometimes often or not the plan sponsor?
Mr. Reilly: No. Well, it could be the --
Ms. Carlisle: It could be.
Mr. Reilly: It could be an independent trustee or it could be an employee directed -- it could be an employee trustee.
Mr. Piacentini: Are any of these answers different in the case of a leveraged ESOP, sort of at the beginning where there's this big transaction taking place versus down the road in annual valuations?
Mr. Reilly: From a valuation perspective, I would say no.
Mr. Piacentini: Okay.
Ms. Carlisle: Now, can I -- can I just -- I'm not an appraiser but I -- you know, I am a lawyer that deals a lot with appraisals and my view has always been valuation is an art, not a science as we've talked about. There is always a range of appropriate answers and fair market value will be within that range, between a willing buyer and a willing seller regardless of what point in time the transaction is appraised or values are determined.
Mr. Goldberg: Yeah, I would just add quickly if your question at the end there was the difference between a transaction versus ongoing ESOP, I think one difference would be when presented with a range of values a trustee who's negotiating a new leverage transaction would be able to use that range to try to negotiate a deal of let's say the low end of the range, but understand what room the trustee has in the negotiations to try to get to a deal with a third party who may be wanting to get the highest price they can get for their shares. Whereas, in an ongoing ESOP valuation, the consideration's still there, I think, in terms of range, the appraiser still may report a range, but now you get a trustee who's making decisions not about acquiring shares or selling them as much as kind of running the benefit distribution system of the plan and the annual administration in where the trustee feels the value should fall within that range for administration.
So I think those considerations are probably different ones, more external dealing with a third party transaction whereas the others are more internal.
Ms. Carlisle: Yeah, it's still -- you're always concerned about in the annual appraisals what are you allocating to your participants this year that will impact the allocations to participants in subsequent years, so you have to be extraordinarily careful in all appraisal situations.
But this -- this whole concept of what is an appraisal -- is the range going to change and the like? Remember, an ESOP trustee is required to not pay more than fair market value. I can certainly pay less, okay? So that range does not preclude me from negotiating a deal less than the range.
Mr. Piacentini: Okay. Let me ask just one other question. So in this general topic of ranges and whether they vary or not, depending on who the client is and so forth and how wide ranges might be sometimes, there is some academic research in this area that's come to my attention.
Let me cite just one example. I just want to see whether some of you have looked at some of this or other research and whether you have a reaction.
So this is a 2002 Harvard study by Moore, et al. And one of the findings of the study and one experiment they carried out with 112 auditors, auditors for buyers valued a deal at 12.3 million while auditors for sellers valued it at 21.4 million. So that strikes me as sort of a wider range than we've mostly talked about except where we were talking about abuses.
So I wonder if there's any reaction to that.
Mr. Goldberg: Well, I'm not familiar with that study.
Ms. Carlisle: I'm not.
Mr. Goldberg: But I think off the top of my head, my reaction to that would be this is just buyers and sellers out in the marketplace who have so many different things --
Ms. Carlisle: It is.
Mr. Goldberg: -- going on in terms of strategic players in their industry versus not.
You know, what an ESOP appraiser's supposed to do is figure out willing buyer, willing seller, the Revenue Rule 59-60 standard, which does narrow the road a little bit.
You know, I think you'd find the range of values when someone is -- when an appraiser is told give me a valuation under 59-60 versus I've got a friend here who wants to sell their company, let's talk about a range of reasonable values out in the marketplace.
Mr. Piacentini: But in terms of the credentials and the standards that you all said applied, within the profession they'd be the same in both circumstances or not?
Ms. Carlisle: Yes.
Mr. Goldberg: The credentials?
Mr. Piacentini: The credentials and --
Mr. Goldberg: Yes.
Mr. Piacentini: -- standards that apply within the profession?
Mr. Goldberg: Yeah, I think that would be the same.
Mr. Piacentini: Thank you.
Mr. Davis: Thanks, Panel 8.
Thank you very much.
Ms. Carlisle: Thank you.
Mr. Reilly: Thank you, sir.
Mr. Davis: Panel 9. We'll make an orderly transition.
Panel 9 is Donna Walker with the American Society of Appraisers, Larry R. Cook representing Larry R. Cook Associates and Jeffrey Tarbell, representing firms that provide valuations and fairness opinions.
You guys all set?
Ms. Walker: I think so.
Mr. Davis: Okay. We'll start with Donna Walker representing the American Society of Appraisers.
Ms. Walker: Good morning. Thank you.
The American Society of Appraisers appreciates the opportunity to testify today at on EBSA's proposed fiduciary rule, which would broaden ERISA's definition of the term "fiduciary" to include individuals who provide ESOP related appraisal services.
My name is Donna Walker. And I'm testifying on behalf of the ASA. By way of personal background, I'm an accredited senior appraiser credentialed by ASA in business valuation and have been providing ESOP related services since 1984. I'm a developer and teacher of the ASA course on ESOP, valuing ESOP shares and I'm all the past president of the ASA and a current member of the Business Valuation Discipline Committee of ASA.
The American Society of Appraisers submitted some extensive written comments expressing our strong opposition to the proposed rule. ASA is sincerely interested in working with the Department to address demonstrated patterns of weakness in the reliability and independence of ESOP valuations and to explore the most cost-effective way to strengthen the ESOP valuation function.
We believe the current proposal is both inappropriate and a counter-productive response to EBSA's concerns. In our view, the proposed appraiser as a fiduciary approach is inappropriate for several reasons:
First, because it is totally unproven as a method that is likely to enhance the quality of appraiser services.
Second, it is inconsistent with the appraiser reform programs adopted through the rest of the government by every federal agency with the responsibility for administrating or regulating valuation services, including the Internal Revenue Service.
And, third, because it would force thousands of professionally credentialed appraisers who provide ESOP services, including those who adhere to the Uniformed Standards of Professional Appraisal Practice or as it's commonly referred to as USPAP, to violate their ethical obligation to be independent of all parties and interest involved in a transaction including an ESOP appraisal.
It is also ASA's view that the proposed rule is actually counter-productive not only to the general public policy purposes of ESOPs, but also to the specific interest of the very people the proposal is supposed to protect, the employee/owners of ESOP plans and the protection of those plan's assets.
The Rule as proposed, would impose significant financial burdens on the ESOP appraisers by requiring them to purchase, in addition to standard E&O insurance, special high cost E&O policies, which would cover the enhanced liability for the liability risk of the fiduciary status.
Moreover, the increased exposure to personal liability that the proposed Rule creates will drive many highly experienced ESOP appraisers out of this practice area, thereby sharply reducing the pool of qualified individuals available to value employee plans.
In our opinion, the bottom line is that the proposed Rule will increase the cost of ESOP valuations and these costs will ultimately be borne by the sponsors and employee beneficiary of those ESOP plans.
If imposing fiduciary status on appraisers were the -- was the only way or even the best way to improve both the independence and reliability of ESOP appraisals, then the negative and disruptive results discussed would perhaps be unavoidable. But the appraiser as fiduciary approach is neither only the best way to address the Department's concern -- it's neither the only best way to address your concerns but indeed in our opinion, it will create many more problems than it solves.
While the ASA does not doubt that faulty or even abusive ESOP related appraisals occur on occasion, the collective judgment of our most experienced members in this area of appraisal practice is that problematic appraisals are rare and that a pattern of such abuses just does not exist.
But even if it did, there is a way to strengthen ESOP valuations that is not only proven but avoids the proposed Rule's two most negative effects, which undermine -- is the undermining of the independence of ESOP appraisers and the substantial increase in cost in performing ESOP valuations.
We respectfully urge EBSA to adopt the appraisal reform model being utilized successfully by all other Federal agencies with important valuation responsibilities. Specifically, reliance on professionally credentialed appraisers who have demonstrated valuation competency and who are legally prohibited from self-dealing and who are fully accountable for the integrity of their work, either to a state appraiser licensing board, in the case of real estate appraisals or to a recognized professional appraiser credentialing organization in the case of business valuation appraisals.
An appraiser's failure to be independent to adhere to generally accepted appraisal standards when performing an appraisal can, and does, result in imposition of sanctions, including in the most serious cases, a loss of a license or a credential.
Importantly, Congress thought highly enough of this type of appraisal reform model that we are urging adoption of, that it was made part of the Dodd/Frank Financial Reform and Consumer Protection Law for the purposes of insuring the integrity of appraisals in connection with mortgage loans and other collateralized extensions of credit.
Also important, is that this same basic appraisal reform model is in effect at the Internal Revenue Service in connection with ensuring the independence from a liability of valuations for a variety of tax related purposes, including the billions of dollars annually in non-cash charitable contributions.
We highlight this fact that the IRS utilizes this model because of the mutual responsibility and interest that EBSA and IRS share in assuring the ESOP plans comply with Federal laws and properly safeguard the assets of plan beneficiaries. This strong mutuality of interest and responsibility extends to ensuring the integrity and reliability of ESOP valuations.
Indeed, in Chapter 12 of EBSA's enforcement manual it discusses and describes the agreement between the DOL and the IRS for the coordination of investigations of employee benefit plans. Additionally, one of the required elements of qualified -- of qualified pension, profit sharing and stock bonus plans under the Internal Revenue Code involves the use of independent appraisers to value plans and their assets. This relevant provision states and I quote:
"A plan meets the requirements of this subparagraph if all valuations of employer securities which are not readily traded on an established securities market with respect to activities carried out by the plan are by an independent appraiser.
For purposes of the preceding sentence, the term 'independent appraiser' means any appraiser meeting the requirements similar to the requirements of the regulations prescribed under section 17(A)(1)."
IRS regulations and guidance pursuant to Code section 170, established the particulars of who is a qualified appraiser and what constitutes a qualified appraisal in connection with the deductibility of noncash charitable contributions and for other certain tax-related valuation purposes. Our February comment letter discussed this in detail on Pages 3 and 4.
ASA's comment letter to DOL on the rulemaking proposal noted, approvingly so, that DOL has proposed but not yet adopted, regulations relating to prohibited transaction exemptions whose valuation components move in the direction of the IRS valuation requirements.
Given the closely aligned responsibility and interest of both the DOL and the IRS, with respect to ESOPs and ESOP enforcement actions, and given the migration of the proposed EBSA valuation requirements for prohibited transaction exemptions in the direction of those required by the IRS for many tax purposes, and given the overall success of Federal agencies reliance in professionally credentialed appraisers to value tangible and intangible property in many of the most important federally related transactions, we strongly believe that the adoption of valuations requirements similar to those adopted by the IRS for all ESOP valuations is both logical and very desirable.
This concludes my testimony. I thank you for your -- the time and I'll be ready to answer any questions you might have.
Mr. Davis: Thank you.
Mr. Cook: Yes. Thank you very much.
My name is Larry Cook. I am the owner of Larry Cook and Associates, P.C. in Houston, Texas. Thank you for allowing me to provide testimony today at the Department of Labor Fiduciary Definition Hearing.
I can only hope that my testimony along with many others opposing the proposed definition expansion of fiduciary to include appraisers will provide the catalyst for reassessment and overcome this rule change.
It is with strong conviction that I come to Washington today compelled to respectfully oppose the manner, the fiduciary definition rule seeks to strengthen the reliability of ESOP valuations. In my opinion, if this definition of fiduciary prevails, it will spell the demise of small company ESOPs. It will force a substantial number of qualified appraisers to end their services to ESOPs.
I think it important that my testimony come from my direct personal knowledge and experiences from several career perspectives of which I've served for the past 38 years.
I was out of college two years and an officer of a small private construction company when ERISA became law in 1974. As part of the cessation plans of those -- of a sole shareholder of this company, I researched, recommended and assisted in implementing a new retirement plan called an ESOP.
At age 27, I became a beneficial stockholder of the company that I worked for through this employee stock ownership plan. I served as a plan administrator for the ESOP and a longstanding profit sharing plan. When I left the company after about 11 years of service, I was fully vested in both plans.
As a result of my activities with the ESOP, I chose a career path as a business appraiser. Over the next decades, I have worked with business owners and management of private businesses in a variety of successful engagements that include the implementation of employee equity, incentives and ownership through ESOPs.
For the past 28 years, I've provided business appraisals for ESOPs. I have served several appraisal organizations at the national, state and local level. I've published a book, Financial Valuation of Employee Stock Ownership Plan Shares. I've co-authored a technical book of valuation -- Financial Valuations, Applications and Model with James R. Hitchner and others.
I believe in the detail and the ideals of capitalism and that all employees can share in the opportunity to be enriched through a beneficial ownership of equity in the very company in which they work; in a system where a shareholder of a private company has a mechanism of passing their equity shares to employees for their retirement.
On numerous occasions, I've experienced the incentivized power of a well-implemented and managed ESOP. I've witnessed the overwhelming strength the participant of an owner of the company has from a janitor to an engineer. I have lived the American Dream of company ownership and spent a career promoting its benefits to others.
This is why I've traveled to D.C. today to represent not only myself but the collective views of the valuation members of the Financial Consulting Group, the Loren D. Stark Company and a voice for many companies' shareholders and employee participants in hopes of providing a perspective that will assist in the continuation of that aspiration of widespread employee equity ownership.
In an attempt to minimize repetition and in the interest of time, I hope to convey three straightforward points that this change and definition brings from a plan, a participant, a sponsor, a fiduciary and an appraiser's perspective.
Number one, risk. In the proposed rule change context, the appraiser would be held personally responsible for any damages incurred by a plan participant as a result of a breach of duty.
As it stands today, without the proposed rule change, I wonder what my responsibilities will actually be. Will this duty extend to acts of management of the company? Will corporate and participant transactions entail a duty? What and how is control over the plan assets extended to the appraiser? Will the appraiser be held liable for actions of co-fiduciaries? Who would bring an action against the appraiser in this context? What actually is the statute of limitations responsibility of the appraiser?
Looking back 30 years, I can't help but ask myself if informed with a certainty of my person, and profession being exposed to this level of risk and liability as currently proposed in this definition change, I would undoubtedly have chosen a different career path.
Number two, conflict of interest. The appraiser in the context of the proposed rule change will act solely on the behalf of participants and their beneficiaries with undivided loyalty. In reflecting on the proposal, I have asked myself these among others:
Will the duty of the appraiser be likened to a power of attorney where decisions are to be made solely on a principal's behalf? How will the appraiser exercise discretion or control over the plan and the administration of benefits to participants? How will the appraisal satisfy the professional ethics and standards of the appraisal societies with which they are members, where this proposed definition change runs in direct contradiction to those core standards?
How many -- how very different this is than where appraisers practice today. And how the conflicts of interest landscape will change should this proposed definition rule be confirmed and allowed to stand.
I come back the same conclusion, this proposal is incompatible with the results -- with the realities of professional standards and the practice of financial valuations. Impartiality, objectivity and independence collectively spell professional neutrality and speak to those foundational standards that anchor the appraisal profession for all of us.
The proposed rule will pose an uncompromising risk and conflict of interest to appraisers and the users of their services. Appraisers will no longer be independent or impartial of all parties in interest involving the transactions or annual valuations of participant accounts; a sobering reality for us all to be aware of.
Number three, cost. Why is it that professional liability insurance is so specific to exclude coverage of fiduciary responsibility and more specifically, those related to ERISA? We know that the cost of insurance will increase the cost of ESOP valuation services. And any increase in cost to the plan or the sponsor of the plan will negatively impact the plan participants. In this proposed rule context, appraisers will assess the potential cost of exposure to expanded litigation environment.
Additionally, regardless of the appraiser's insurance coverage, or the merits of litigation filing, the added risk factors will necessitate the appraiser's consideration of exposure to deductibles, the energy for furnishing documents and the disruption of services to other engagements.
With widespread reasonably priced professional liability coverage that extends to cover the appraiser as a fiduciary, few professional appraisers will assume the personal liability. Additionally, and assuming an adequate liability coverage is afforded, there remains the haunting cloud of expanded litigation, defense of the appraiser's work product, not to mention the proposal runs foul of all independent standards.
The proposed rule will impose costly unnecessary and unrealistic burdens to the appraiser and the plans they serve.
As my friend in Houston with over 50 years experience with thousands of ERISA plans, Don Stark of the Loren D. Stark Company said, and I quote: "The single largest expense to a small ESOP is the cost of the appraisal. Should the Department of Labor fiduciary proposal prevail it would undeniably increase the cost of an appraisal and that alone will signal the end of the small ESOP."
Finally, painting a picture of the existing climate of private business trends transitioning from one generation to another, we are in the midst of a baby boomers that closely held companies transacting their equity ownership. The next eight years or so will mark the most significant transitioning by selling, gifting, contributing or liquidating nonpublic company ownership perhaps in our country's history. It is the time where the option of transitioning private company equity to the next generation can be made in whole or in part using an ESOP as the transition of choice for those companies that have a workforce and management to possess that think like owners culture to do so.
Because of the level of personal liability that will be imposed on appraisers, the significant cost increase to the appraiser and further to the ESOP and the conflict of interest posed under this proposed rule I respectfully and vehemently disagree with the potential rule.
With my years of professional experience involved in ESOPs and their valuation, it is my professional and personal belief that this proposed rule will nail -- will be a nail in the coffin for small ESOPs.
I plead with the Department of Labor to reconsider this proposal and against the best interest of ESOPs and their participants.
That concludes my testimony. And, again, I thank you for allowing me to be here today.
Mr. Davis: Thank you so much. Mr. Tarbell.
Mr. Tarbell: Thank you.
Good morning. My name is Jeff Tarbell and I'm a director with Houlihan Lokey and I have more than 20 years of experience rendering valuations and fairness opinions related to employee stock ownership plans or ESOPs.
I'm testifying on behalf of seven firms that provide ESOP valuations and fairness opinions and these firms are believed to be -- to have some of the largest and most active ESOP valuation practices in the industry. In fact, the professionals in these organizations are arguably the most experienced and qualified professionals currently providing such services.
As set forth in our comment letter, we have serious concerns about the impact of the proposed regulation on our professional responsibilities and on the more than 10 million active and retired employees who rely upon their company's ESOP for their retirement security.
We strongly believe that ESOP valuation and fairness opinion providers should continue to be excluded from the definition of investment advice for the following reasons:
First, we believe the longstanding rationale for excluding ESOP valuation and fairness opinions remains valid today. As the DOL noted in its 1976 advisery opinion, an ESOP valuation or fairness opinion does not make a recommendation as to a particular investment decision. It does not address the relative merits of purchasing employer securities and it -- nor does the ESOP valuation or fairness opinion provider have any decision-making authority over a trustee's decision whether to purchase or sell the employer's securities.
In other words, ESOP -- an ESOP valuation or fairness opinion does not constitute investment advice. And I would respectfully, strongly disagree with the assertion made previously that the valuation provider is the center of an ESOP transaction. That is the trustee's job.
Consequently, we do not understand why providers are singled out for fiduciary treatment when control over the terms and conditions of an ESOP transaction actually lie with other parties to the transaction.
Second, we are not aware of evidence that can -- conflicts of interest or incorrect or biased valuations are a common problem in ESOP valuations and fairness opinions. In fact, at the conclusion of my remarks, we would appreciate if the panel would respond to the question of whether such evidence exists and if it does exist, we would ask the DOL to make the evidence publicly available in order to allow an opportunity for public comment.
With respect to conflicts of interest, it's my understanding that none of the seven firms for which I speak perform ESOP valuations or fairness opinions for contingent compensation and each firm's fee arrangements are fully disclosed in their engagement letters.
Third, we submit that the proposed regulation is at odds with the impartiality and independent requirements under professional standards of valuation practice as well as the Internal Revenue Code.
Professional valuation associations such as the ASA and the AICPA require their members to approach and perform valuations with independence and impartiality. Making a provider of ESOP valuations or fairness opinions a fiduciary, does effectively make them an advocate and partial to plan participants, and it therefore, violates the ethical guidelines of these associations as well as the fundamental principles of independent appraisal.
In addition, as Ms. Walker explained more fully, under the Internal Revenue Code, valuation providers are required to provide an independent opinion of value. The IRS looks to generally accepted appraisal standards to determine if a valuation has been conducted impartially and independently including the principles embodied in the Uniform Standards of Professional Appraisal Practice. It is clear under both the Internal Revenue Code and well-established professional standards, that the role of the valuation professional is not to advocate for a value or an investment on behalf of anyone, instead to provide an impartial and independent opinion of value.
And, again, I would strongly disagree with the assertion made previously that the range of value is dependent upon the client who hires you. Our task is exactly contrary to that. Our task as an independent valuation firm is to provide a range of value independent of who hires us.
Fourth, we believe the proposed regulation would have serious unintended adverse effects by decreasing the service value to ESOP companies and plan participants. If the proposed regulation is finalized in its current form, ESOP valuation opinion -- ESOP valuation and fairness opinion providers will need to purchase fiduciary insurance, incur ongoing legal fees and expand their scope of non-valuation and fairness opinion work. This will dramatically increase the cost of providing such services. And I'll be happy to discuss cost if you have those questions, as I believe you probably will.
Those costs will be passed on to ESOP companies and ultimately affect the balance of plan participant accounts. The overall quality of ESOP valuation and fairness opinions may drop because many firms, including the firms in our group, will have a significant disincentive to continue providing ESOP valuations and fairness opinions in light of increased risks and oversight.
In fact, we believe that it is unfortunately the larger firms with the most qualified and experienced professionals perhaps who generally have other sources of business that are the most likely to leave the ESOP market. Consequently, we believe more valuations will be performed by low cost providers who sometimes compensate for a lack of experience and training by offering their services at low prices.
Fifth, we believe that the relationship between an ESOP trustee and an ESOP valuation and/or fairness opinion provider will be undermined by making the provider a co-fiduciary. In a proposed transaction, the parties have a very clear understanding of their roles.
The ESOP trustee's role is to conduct a prudent investigation as to the merits of a particular investment decision. And as part of that process, the ESOP trustee normally retains ERISA counsel and an independent valuation provider to assist them in evaluating the financial terms of the proposed transaction including obtaining an opinion as to the value of the employer's securities proposed to be purchased or sold, which opinion the independent trustee reviews and analyzes. That valuation opinion is only one of many factors that is considered by the trustee when they make their investment decision.
For example, the advice provided by legal counsel as to the terms of a particular transaction, which is certainly material to the overall economic value of the proposed deal -- excuse me, and yet, the attorney would not be deemed a fiduciary under the proposed reg.
Were both the trustee and the valuation provider co-fiduciaries, these well-established relationships are disrupted. For example, the ESOP trustee may -- simply may cede financial issues to the provider thereby eliminating the benefit of a rigorous review of the valuation or the ESOP valuation provider may not be able to cede final decision-making authority to the trustee on areas of disagreement creating confusion, expense and inefficiency.
For example, if the valuation provider provides a range of value and the trustee decides to purchase shares for a price other than the mid point of that range, as the co-fiduciary under the proposed regulations, what would you propose the valuation provider do?
The question comes down to who's in charge and who holds ultimate responsibility for the investment decision, which is clear under the current reg but just the opposite under the proposed regulation. As a result, an ESOP company may decide that retaining two co-fiduciaries is expensive, unnecessary, and problematic and therefore, the ESOP company may eliminate the independent trustee in favor of an internal trustee or committee, or eliminate the trustee role entirely which would eliminate a critical part of the prudent investigation process.
For these reasons, we urge the Agency to modify the rule in the following respects:
First, the DOL should create a safe harbor for valuation and fairness providers, allowing them to perform traditional ESOP related services as a non- ERISA fiduciary. As long as the valuation or fairness opinions provider does not exercise decision-making authority over the investment decision, does not render advice concerning the relative merits of a proposed transaction or any available alternative transaction, and does not provide individualized investment advice to the ESOP or the participants on investment policies or strategies or folio composition or diversification of plan investments.
Rather, the provider's only role is to provide an independent and impartial opinion of value. The fact that the provider does not have decisionmaking control in a particular transaction is consistent with the treatment of fairness opinion providers outside of the ESOP context where the company's board, not the provider of the opinion, bears the decision-making authority and responsibility on behalf of the company shareholders.
Second, if the DOL's aim is to provide guidance on critical ESOP valuation issues, the DOL can do that directly. Many providers of the ESOP valuations and fairness opinions are members of professional valuation organizations that continually examine complex valuation issues including those related to ESOPs. We're confident that such organizations would welcome DOL's participation in such discussions.
In closing, I would like to emphasize that we approach valuations of privately held ESOP stock seriously and rigorously. We well understand that these valuations affect the retirement assets of ESOP plan participants. We disagree with the Department's assumption, however, that making us fiduciaries will somehow change or improve how we conduct our financial analysis.
If there is a problem with substandard quality of work in preparing ESOP valuations and fairness opinions, it likely derives from inexperienced and unqualified providers. And making those parties fiduciaries is not going to transform them into experienced and skilled professionals. It will, however, put us in direct conflict with the independent requirements of our profession, create legal uncertainty and impose responsibility on us without any actual decision-making power or authority.
Thank you for the opportunity to testify and I welcome your questions.
Mr. Davis: Thank you.
Ms. Borzi: I want to thank all of you for your testimony. Just a couple of questions.
You have -- I didn't -- I can't -- I didn't count the numbers of experience, but you clearly have many years of experience in the valuation context, so can you give me a sense of how often in your experience does the ESOP trustee rely on the valuation that they've been given by the valuation expert?
Mr. Tarbell: Are you asking me?
Ms. Borzi: I'm asking any or all of you.
Mr. Tarbell: In my experience, their task is to rely on it in part, but it is ultimately the trustee's responsibility to determine valuation.
Ms. Borzi: Have you -- so they generally do rely on it. Are there experiences that any of you had where the valuation that the ESOP trustee is given, the ESOP trustee has said I want a second opinion or -- is that a common industry practice?
Mr. Cook: I can give you a -- I hope this works. I can give you a specific situation and it goes to answer one of your questions from the previous one.
Ms. Borzi: Sure.
Mr. Cook: This is a real live one where they were terminating an ESOP; they were terminating a plan. The company did not own the -- the ESOP did not own it 100 percent. I can't recall exactly the percent. It's been years ago. But the trustee went out and didn't get one but two valuations independent of one another. There was an 18 percent disparity between the values on terminating the plan.
I was asked to come up and take a look at that plan and see which of the two were the most reasonable to assist that trustee in making that determination.
Ms. Borzi: Sure.
Mr. Cook: If I were to follow the proposed definition of fiduciary, my duties would be for the sole benefit of those employee participants. I am now in a pretty big quandary. Is it the 18 percent higher one or the lower? Because it was clear -- it would be clear that that one that was 18 percent higher would be in the benefit of those employee participants. Unlike the reality was, the lower value was the one I considered to be closer to that of reality.
I now am placed in a position of making the decision as the trustee should have, of which that trustee would rely on. That makes it the case for exactly what we've been talking about here. We have to be independent, we have to be objective and impartial in doing the work that we do.
I can tell you categorically that the trustees in these small plans rely on what I give them.
Ms. Borzi: Yeah, I'm going to get to the impartiality question in just a minute. What I'm really trying to see is from the point of view from your experience and from your point of view when you give an opinion there is certainly an expectation that the trustee will rely on it, not exclusively necessarily as you point out, but obviously when you give that opinion you're using your best judgment and you're assuming that the trustee's going to rely on it?
Mr. Cook: Yes.
Ms. Borzi: Am I incorrect in making that assumption?
Mr. Cook: In my circumstances that would be the case.
Ms. Borzi: Okay. So the notion that obviously you took some offense that that the valuation, the person doing the valuation is at the center of the transaction is -- is not as off-the-mark as you seem to suggest. Would a trustee go forward without a valuation opinion?
Mr. Tarbell: Well, I think that -- I'll respectfully -- we'll agree to disagree on the point, but the trustee needs to make the decision on whether to go forward or not.
Just like when I buy stock that's publicly traded, I need to know the price before I make the decision.
Ms. Borzi: Right.
Mr. Tarbell: But the price alone doesn't tell you whether to buy or sell it. There's fantastically more --
Ms. Borzi: But the price is an essential part of the decision-making tools that you use.
Mr. Tarbell: It's essential, but in a private company -- and, you know, if you're dealing with a public stock, it is a dominant decision factor. If you're dealing with a private company, there are, you know, there are dramatic other things, a dramatic number of other factors that the trustee should consider.
Ms. Borzi: Like?
Mr. Tarbell: The quality of the management. Their opinion of the -- is this a -- you know, is this is a declining industry or an upward industry. The structure of the transaction do I believe this is too much debt on this leverage, the ESOP deal or not.
I mean, we provide a -- you know, I don't mean to dismiss it or minimize its importance but we provide a mathematical number. And, again, it's one of many factors. But once we provide that piece of information to the trustee, they seek, you know, a tremendous amount of legal advice and have a responsibility to then decide without our input whether or not to enter into the transaction. So there's a big difference between providing a piece of information. That's important, and deciding whether or not to pull the trigger and do the deal or not.
Ms. Borzi: Okay. One other short question and then I'm going to get to the impartiality discussion. And that is, Mr. Tarbell, you suggested that in a big company context where big companies have as part of their services that they offer ESOP valuation, that were the Department to move forward in some form of this proposal which would make the person providing the valuation opinion a fiduciary for purposes of that opinion, and that's actually something that I was concerned about and the way you described this, Mr. Cook.
Fiduciary duty attaches only to the duties that you actually perform. It doesn't make you broadly liable for any other thing that could possibly take place. So to the extent that you would render a fiduciary would be -- if a person were a fiduciary and the -- the fiduciary activity that they would be engaging in, is rendering an opinion, all those peripheral things that the ESOP trustee would be responsible for, a co-fiduciary would not be responsible for. You're only responsible for the things that -- the duties that you perform.
So back to my question, I got sidetracked here. So are you basically saying that Houlihan Lokey would withdraw from this business?
Mr. Tarbell: Well, we'll make the decision if the rule passes. But I would say that there's a strong opinion in my firm as to -- by those who make those decisions that that's -- this is an unacceptable amount of risk relative to the revenues that we generate from this business.
Ms. Borzi: Okay. What percentage of your revenues is generated from this business? Do you have an idea?
Mr. Tarbell: Less than 1 percent.
Ms. Borzi: Okay. Now I want to get to the - - the question -- I don't know whether you were in the audience when we were -- I was talking with the other panel about this, but I -- I see no conflicts between the duty that you have under the Internal Revenue Code to render the most correct opinion and the duty you would have under fiduciary rules, because the fiduciary rules do not -- do not require you to be an advocate for the participant.
What you would be required to do is basically do the same thing that you're supposed to be doing under the Internal Revenue Code which is to render the best opinion you can with the same kind of impartiality and independence. The fact that it's -- that the duty flows to the participants and beneficiaries, the participants and beneficiaries do not expect, nor would they be entitled to expect that you put your finger on the scale in their favor. They have the same objectives of an opinion that is in the best -- the most correct that you could possibly render that's impartial in an independence -- independent form.
And I just -- I'm wondering -- and if you look at the ERISA case law you'll see that that's what the courts have said. So I'm wondering why it is that you think that these are -- I know you strongly believe it, I'm not -- I'm not disputing that you strongly believe -- feel strongly about this and I respect that. But I'm wondering what evidence you have that that would be the result?
Mr. Cook: With the difference between what IRS does?
Ms. Borzi: Right.
Mr. Cook: Well, that wasn't part of my testimony, but I'll be more than happy to address --
Ms. Borzi: Well, I think it's more of a subrosa, a part of what you were concerned about because you said this would require you to -- I forgot the third word, I didn't write fast enough to get the third word you used.
Mr. Cook: Sorry.
Ms. Borzi: But you said that if this proposal were adopted you could no longer render an impartial or independent opinion or whatever that third word was.
Mr. Cook: Anything that will create any independence question or impartiality question, and a fiduciary does that in my opinion, changes the balance and the landscape of what we work through as one of our bedrocks to doing valuation work. A fiduciary responsibility in my mind puts me in a different place than I am now. It's obvious in a different place or you wouldn't be bringing this up.
Ms. Borzi: Yeah. So if we said in the regulation --
Ms. Walker: May I make a comment on your question?
Ms. Borzi: Certainly.
Ms. Walker: I guess, accepting what you just said that our role would be exactly the same, then I guess my question to you then why impose a fiduciary status on us, because it has negative consequences and I don't think it gets to what I perceive to be your ultimate concern which is about the quality of appraisals and appraisers.
And I think by -- I don't think fiduciary status is -- equates to competency.
Ms. Borzi: Well, the question really is: In terms of -- in terms of qualifications, impartiality and independence is part and parcel of the duty that you have. And if what -- let me just turn the question on its ear here.
If what you're telling me is that everyone who renders a valuation opinion does so with the utmost conformance to the independence impartiality standard, part of competence is -- are these features. So, therefore, what -- the only difference I see is that under a regulation, which holds you to those standards, we would have a method of enforcing it if those standards warrant that. And -- which is where I was going a minute ago.
And so, to the extent in a regulation, in the same regulation that imposed these kinds of duties, we made it clear that the nature of the duty with respect to impartiality and independence is exactly the same duty that you would have now under the Internal Revenue Code.
Would that make you feel a little more confident that -- that we would not be asking you to do something like putting your finger on the scale for the participants?
Ms. Walker: Let me respond to that. Again, I go back to that I am going to do that anyway. I do that anyway. I have to because I'm an ASA. I have to follow USPAP and I'm --
Ms. Borzi: And what are the enforcement mechanisms?
Ms. Walker: I'll tell you.
Ms. Borzi: Okay.
Ms. Walker: And I follow USPAP, and I work - - I do work for -- before the IRS and so I know I must follow their rules and regulations, and their rules and regulations as they apply to ERISA.
So I still say I do that, but I do not want to have the fiduciary status, because it gives me other issues of costs and risks that I don't think are --
Ms. Borzi: Yeah, I get that, but I'm --
Ms. Walker: -- appropriate.
Ms. Borzi: -- just trying to address this one issue here.
Ms. Walker: Well, I think -- I guess I have -- I think I have addressed it. I'm saying, we -- we will -- qualified appraisers will follow independents and lack of bias and they don't need a fiduciary duty to do that.
Ms. Borzi: And what happens if they don't?
Ms. Walker: Okay. Well, I think under -- if they follow USPAP or they're a credentialed appraiser, they can be brought up for violations of their professional practices under ASA or USPAP and they can be brought for violations. We have an ethics procedure where people -- anyone --
Ms. Borzi: Are they then debarred? What happens?
Ms. Walker: They may be. There are several -- the process is that you have to have a written complaint. There's some process, there's an ethics committee that looks at these and there are -- there are a number of possible outcomes. There are called suggestions where you do something that is considered to be unethical or against professional practices and you are suggested a way to correct it. You're supposed to take a course or something.
Ms. Borzi: Uh-huh. And is there -- so you take a course?
Ms. Walker: Okay. Well, that's the -- that's the minimal. You could be censured. You can be suspended and you can be expelled.
Ms. Borzi: Okay. And if -- and what happens if after those --
Ms. Walker: So then you can no longer hold yourself out as an ASA. If you do some -- the IRS has --
Ms. Borzi: Do people render these opinions if they're not an ASA, if they don't have those letters after their name?
Ms. Walker: They may, but I think we're advocating that by looking at credentialed appraisers, you will have people who've got the experience, the education to give competent appraisals.
And the IRS has -- has sanctions against appraisers. You may not be allowed to practice before the IRS and that's --
Ms. Borzi: And do you have a sense of how often they're applied?
Ms. Walker: They have an Office of Professional Practice that is looking into that.
Ms. Borzi: Well, we'll certainly reach out and explore those things.
Ms. Walker: And so -- and they are doing that. So I think appraisers who work before the IRS certainly take those as serious consequences and have looked at the IRS's new requirements of what is a qualified appraiser and a qualified appraisal. And I think those are credentials that, as we said in our testimony, the IRS has accepted and other agencies have accepted and they are proving to be workable models.
Ms. Borzi: Okay. I don't want to take anymore time, but thank you for your suggestions and your testimony.
Mr. Tarbell: May I just make one comment?
Ms. Borzi: Sure.
Mr. Tarbell: The ultimate enforcement in our industry is that you don't get hired again. And to the extent that someone is, as you said, as Donna said, expelled from the ASA or to the extent that they do biased or non-independent or just schlocky work, and they are still getting hired by a plan trustee who is accepting their valuations, then I think -- I think what we have here is a trustee problem, not an appraiser problem.
Ms. Borzi: How -- how do trustees know that -- is this made public? Is there a press release if you're expelled from the ASA? How do --
Ms. Walker: It's published. I mean, it's not in the New York Times but it is published.
Ms. Borzi: But where is it published? Or --
Ms. Walker: I mean, you should be able -- if someone holds themselves out to be an ASA --
Ms. Borzi: No, I'm saying they're not. So you --
Ms. Walker: Yeah, you should be able to --
Ms. Borzi: So you expel them. They take those three letters off their resume, but they still hold themselves out.
Ms. Walker: But they would have to -- you would have to look into the person's background. I mean, they're not going to tell you in its -- if you call the ASA they would probably give you that information.
But, again, I guess I agree with Jeff's point about that is that I think there is some responsibility on the trustee to interview and understand --
Ms. Borzi: Unquestionably.
Ms. Walker: -- appraising --
Ms. Borzi: Unquestionably. I'm with you.
Ms. Walker: They should be able to -- they should be able to find that out and if they look to see if they have credentialed appraisers who have experience, then they should know that those people are interested enough in credible appraisals to, you know, to be -- to have gone to a -- belong to an organization that teaches and tests and requires peer-review of reports and requires continuing education.
So that should tell you as a trustee then that this is a serious professional appraiser.
Ms. Borzi: Okay. I'm going to just stop there, cause I've dominated the time, and I don't want to.
Mr. Davis: Just quickly, I'll ask you -- this panel the same question I asked Panel No. 8. And, I think, Ms. Walker, in your comment letter you talked about the E&O insurance costs going up dramatically if this reg was passed as proposed or finalized as proposed.
Do you have more specifics? And I guess I would ask this of the entire panel, specifics as to, you know, how much would the fiduciary rider cost as a separate policy? Who are the providers? Just be more specific in terms --
Ms. Walker: I don't have any more specifics. I personally for my firm have looked and asked for a quote on those kinds of policies. They don't exist right now, because appraisers have not been fiduciaries before.
Now, I have every confidence that the insurance market will produce a product. How much it will cost I don't know. But E&O insurance is very, I think, quite expensive for the coverage you get. I expect this will be more expensive. So I can't give you a dollar amount but certainly -- and that is just one component of the expense.
I think appraisal firms will have to look at that insurance, they'll have to look at the overall risk, which will mean that they'll have to have more legal counsel. And if -- as a fiduciary, you would have to have legal counsel in every transaction that you were involved in.
So, no, I can't give you a dollar amount. I guess my point is that there is some amount and it will be borne in large part by benefit plans because appraisal firms will try to pass those expenses on to the extent they can to -- to the plan.
Mr. Davis: But in your comment letter, you stated that the cost, it would be extremely costly is what I think your quote was.
Ms. Walker: Yes, I think it will be.
Mr. Davis: So what was the basis of saying that it was extremely costly if you don't have more specifics?
Ms. Walker: Well, because I understand the cost of errors and omissions insurance and I talked just generally about other fiduciary types of insurance is expensive. You know, I can't go out there and price a policy now for -- for an appraisal firm to be a fiduciary. It doesn't exist.
Mr. Davis: Anybody else? Thank you.
Mr. Tarbell: Well, the insurance isn't the only cost either.
Mr. Davis: Yeah, I understand that, but I just want to stay with the insurance topic now. I understand the litigation costs. But just with respect to insurance.
Mr. Tarbell: But there's a component of insurance, which is the retention or the deductible.
Mr. Davis: Okay.
Mr. Tarbell: And my understanding from ESOP fiduciaries is that's about $500,000 normally. I'll go out on a limb but I think, you know, I've done this 20 years, I have a pretty good idea that for a lot of small ESOP providers that's a year's worth of profits.
So, and in other words, and again, we're not concerned -- I don't think we're all concerned about suits from the DOL, what we're concerned about is suits from the plaintiffs part. And, you know, you may interpret the reg one way but there's -- you know, other people have sat at these chairs the last couple days that may interpret them extremely differently.
And to the extent that we have to fight one lawsuit, win or lose, just to get your name off the cover, you know, you may not get to that -- you may not even get into your insurance but you may end up paying the $500,000 and that's enough to put some of these providers out of business.
Mr. Davis: Mr. Cook, did you have a thought?
Mr. Cook: Let me just answer this. The cost of insurance is one piece of this. Okay. This is something I didn't bring in testimony. I will now.
I'm also a registered investment adviser and I hold a securities license. I'm done if this is passed. I'm done, because I handle an outside business activity for the -- as defined by Security Exchange Commission, no insurance will cover. I will remove myself from this and I've done this 38 years now. Either that or I will have to jettison part of -- two parts of my business, the ESOP side of it and the securities side.
There's a cost that goes larger than that of just the premiums; that of defending ourselves to a plaintiff's attorney that is always going to include us, always on anything that goes down inside of an ESOP or any other ERISA plan. Those are the costs that are going to impact us.
We can take conflict of interest as being a great argument. Risk is where we are not going to be able to provide the same thing we provide now. It makes it extremely complicated.
Mr. Davis: Thank you.
Mr. Lebowitz: To my mind, this -- you know, this issue is really about accountability. And I think that's really what we've been talking about mostly this morning.
Ms. Walker, when you -- you took -- let's talk a little bit more about the IRS requirements. Now, if the -- if the appraiser fails the IRS requirements, what happens under the tax law, what's the consequence?
Ms. Walker: Well, under the regulations now for tax purposes, you have to be a qualified appraiser or appraiser.
Mr. Lebowitz: Qualified as they define it?
Ms. Walker: Yes.
Mr. Lebowitz: And if you're not? If you --
Ms. Walker: Well, they say then it's not acceptable --
Mr. Lebowitz: Meaning a deduction is --
Ms. Walker: Yeah, that the --
Mr. Lebowitz: -- there's a tax consequence?
Ms. Walker: Right. That they would not --
Mr. Lebowitz: It's a -- so somebody's accountable in a very tangible way? There's a penalty and the penalty is that a deduction is disallowed, correct?
Ms. Walker: Yes, the IRS will say they don't accept that --
Mr. Lebowitz: So there's nothing comparable on our side. I mean, you suggested we adopt those kinds of standards but -- and, again, to my mind, this is all about accountability about holding people responsible for what they've -- for the actions they've taken.
Under the Code there's a -- there's a clear and tangible penalty for violation of those standards and that is that a tax penalty is applied.
What -- there's nothing comparable on our side --
Mr. Tarbell: There's more than that.
Mr. Lebowitz: There is no deduction.
Ms. Walker: Well, no and the deduction is to the taxpayer not to the appraiser, but there are -- there are --
Mr. Lebowitz: But there is a penalty?
Ms. Walker: There is a penalty of monetary --
Mr. Lebowitz: That applies to somebody. It applies to the client of the appraiser.
Ms. Walker: There is a monetary penalty that can be levied against the appraiser.
Mr. Lebowitz: Okay.
Ms. Walker: And the appraiser can be barred from performing tax-related appraisals.
Mr. Lebowitz: And under ERISA, we --
Ms. Walker: Which is the real hammer.
Mr. Lebowitz: -- have -- we can do neither of those things. There is no monetary penalty, there's no civil penalty for --
Ms. Walker: Well, certainly --
Mr. Lebowitz: -- performing substandard appraisals and there's no -- we have no ability to bar an appraiser from providing services to clients.
Ms. Walker: Well, I think you could probably get that authority and --
Mr. Lebowitz: Would you support legislation to do that?
Ms. Walker: Yeah, I think -- again, I --
Mr. Lebowitz: You would. Would you, Mr. Cook?
Ms. Walker: I think that's a way to look --
Mr. Lebowitz: Can I get an answer from Mr. Cook?
Ms. Walker: Well, wait. Let me -- you haven't let me answer your question.
I think accountability is the issue. And I think under the IRS Code, which also has some authority over ERISA, that perhaps that Code could be enforced.
I do think you should be able to bar people if -- from practicing under ERISA; that's what IRS has done and that has been, I think, something that appraisers who practice in that arena, you get their attention.
Of course, the issue is then we will want to work with you to be sure that those rules and regulations we think are appropriate and we have an appropriate access to be sure that we get due process in that.
But, again, I think our whole idea about looking at credentialed appraisers are the base -- by looking at someone who has a credential, they are accountable.
Mr. Lebowitz: And I agree with that, but again, for someone who's involved in the enforcement operation here, if it's not enforceable, it's a voluntary standard that essentially is the same thing as having a speed limit that would just -- whatever you feel like driving. We suggest it's 65, but you want to go 90, that's okay too.
Anyhow, Mr. Cook and, Mr. Tarbell, would you comment on this? Do you think that this -- that approach that Ms. Walker was just talking about is on - - that would make some sense --
Mr. Cook: Let me --
Mr. Lebowitz: -- to create a statutory standard and one that would be enforceable on a tangible way?
Mr. Cook: We work under that environment currently with the Internal Revenue Service.
Mr. Lebowitz: Not under this you don't.
Mr. Cook: I understand. But, somehow, I'm getting the sense, and I understand it has got to be frustrating from an enforcement perspective. I hear what you're saying. But at the other side of this is it would have seemed from listening to the comments here that it makes -- builds the case at least that's what I'm hearing, that as appraisers in an ESOP environment, we're immune from anyone.
Would not the trustee have a cause of action against us for any errors or acts or omissions or anything that we do? Would they not have a cause of action if you were to pursue or Department of Labor, not you, were to pursue that trustee for a faulty valuation for whatever reason, would not that trustee have a subrogation ability to come back against us? Would not that be their duty to do so? Is it not why we have a trustee with a fiduciary responsibility and it provides us the opportunity to make recommendations and suggests and, yes, opine on exactly what that trustee might be willing to transact those shares with the participants to be?
I think we're in a very compliant position as being an appraiser as we sit here today without the fiduciary requirement.
Mr. Lebowitz: And what we're talking about could well be an alternative to that. In other words, a statutory -- something that's in the statute that prescribed professional standards and also imposed a penalty for failure to meet them.
Mr. Cook: I would --
Mr. Lebowitz: But not fiduciary standard, not with all of the problems that you've -- that you've identified.
Mr. Cook: I believe there is much wisdom in the 1988 proposed adequate consideration. There was a lot of wisdom. If anybody ever read my book, which a few have, you will see that I think that is a bedrock. I don't agree with 100 percent, but if you get 100 percent agreement with everybody, somebody's not thinking somewhere.
But there are so many positive things that are written so specifically in that 1988 ruling that impose things for us as appraisers for what a trustee could lean on as being a -- and to assist them if they do their job right in assessing not only what appraisal firm to hire, but also the valuation itself.
Mr. Lebowitz: I guess that was an answer.
Mr. Cook: It was an answer.
Mr. Lebowitz: Thank you.
Mr. Tarbell: Well, I would disagree with the premise that there is a consensus that there is a problem. But to the extent that something had to change, we would far rather see the IRS model of testing value as to what defines incorrect, monetary penalties on the appraiser and potential disbarment, then we would see the proposed reg pass as it is written.
Mr. Lebowitz: Thank you.
Mr. Hauser: Let me -- maybe following up on Alan's comments earlier this morning, let me just, you know, start with something that's more an observation than a question.
And the observation is that from our standpoint, and we could have a discussion about why the legal framework plays out this way, but from our standpoint, the appraiser, if a fiduciary, would not have a duty to bias their work in favor of the plan. And, in fact, we don't think you're doing a favor to the plan if you give advice essentially that amounts to telling it what it would like to hear as to the price. We think you're doing a disservice in that circumstance, just as we don't think right now that fiduciaries of ESOPs or any other kind of plan should be asking their advisers when they're asking for an opinion to slant the advice or they should be looking for advisers who would slant the advice.
Everybody's job when it comes to getting advice as to what the price should be is just getting it right. Then it's the job of the other fiduciaries to execute on that, to make sensible decisions based on an informed position on what the true range of values is.
And, you know, if you give wrong advice, if you inflate it because they're a seller, you deflate it because you're a buyer, you're doing -- they're a buyer, you're doing a disservice. They need to know what the number really is so they can decide which deals to sensibly forego or not.
So I think that's a complete red herring, I think it's false, but what we can do for sure is make that clear. We can make it clear that your duty does not require in any way slanting an opinion. It doesn't require in any way compromising your impartiality when you render an opinion as to advice and it doesn't require you to exceed the normal scope of your engagement in the sense of getting involved in the mechanics of actually, you know, negotiating on what the transaction price should be. It requires none of that.
So to the extent that there's any anxiety right now that's based on those concerns, that we can and would rectify whatever we do with this regulation. So I don't think that's a problem.
So that, I guess, leads me to the -- a couple questions, and one is I agree, the trustee's job is to -- ultimately, the responsibility rests with the trustee to decide whether or not to move forward with the transaction. And it's a very weighty responsibility. They have to read the report, they have to understand it, they have to identify what the assumptions are underlying it. They have to think about whether any kind of sensitivity analysis was done. They have to ask themselves if the mathematical portion and the appendix actually matches the narrative in the document. There are a million things involved in it. It's very hard.
But the fact is, as Mr. Goldberg from the ESOP Association testified earlier, we're often talking about, you know, small businesses and small owners that they're mainly -- what they know is how to do their operating business. They know how to produce whatever it is they produce. They're not valuation experts and they look to you for that advice.
And what I'm not understanding, and what I'd like you to respond to now after this long lead up, is -- is assuming that the obligation is simply to render a professional, competent, impartial decision that's within the range of professional judgment, recognizing that it is a range, that this is somewhat subjective and it requires judgment, I get the sense from all three of you that you think there's something fundamentally unfair about -- about you being called to account and when the result of your advice is somebody relies on it and the plan is injured by it in the sense of being on the hook for those losses.
And I guess I'm wondering what -- you know, putting aside the issues of costs and benefits, that's a separate discussion, I get the sense that you think there's something fundamentally unfair about you being on the hook if you cause those losses. And I'd just like to understand why that is, because, again, speaking as an enforcement person, it has been truly frustrating to us in some of these cases where it's really seemed to us like the engine that made the deal go was the appraiser, and the price was really, really wrong and it really didn't reflect competent judgment, but that person we can't go after.
We can go after the guy who's running an operating company was also the trustee and relied on you. To me, if anything, that seems more unfair in the current regime, and I'd just like to understand why you disagree because I think you all three plainly do?
Mr. Cook: As one observation to another one here.
Mr. Hauser: Please, only fair.
Mr. Cook: Again, I can't speak for anybody but me. I've been around ESOPs a long time. At the end of the day, I sense from your observation, that there is no pressure that can be applied to me as an appraiser if I really, really, miss it. That's just not true. That trustee has a cause of action against me and my liability policy, assuming I have one, and they -- nothing precludes them from saying if you said it's messed up and you prove that to the trustee for them not to subrogate there, is there? Am I missing something?
Mr. Hauser: Well, I think you are in a sense and maybe you can respond to this too. But the problem for -- I mean, again, remember, the whole framework. And I think all three of you echoed this was that, well, the trustee's really the person on the hook.
So now ask yourself, if I'm a trustee and I think that the valuation went bad, at least -- unless and until some participant or the Department of Labor happens upon it and sues me, don't I have a powerful disincentive not to bring the lawsuit against the appraiser because that's almost putting a target on my back?
If I'm saying I -- I shouldn't have relied on this appraisal because it was incompetently rendered, I'm also saying from a conventional fiduciary standpoint, I breached my duties as a fiduciary in relying on it. That's a powerful disincentive for ever bringing that lawsuit.
And then, the other issue is in a number of these cases what we've seen is that the transactions are, you know, sometimes the abuse is just somebody's gotten the price wrong. They've rendered an incompetent job, it really was kind of imprudent.
Other times it's a company that's being drained in substantial part of its assets for the benefit of a corporate insider. And the fact is the corporate insider is the guy driving the transaction. He's not going to sue you because he's in on the deal.
Mr. Tarbell: Well, you identify a hypothetical there of a trustee who's -- who's reluctant to sue their valuation firm because they've improperly relied on the appraisal. The core of that problem is that the trustee improperly relied on the appraisal. That -- the fact that they've gotten themselves into that mess is not -- is not our mistake.
Mr. Hauser: You don't -- is that what you tell your customers? I mean, they hire you because they think they should be able to rely on you, don't they?
I mean, I'm not saying what's core and what's not core. I'm saying you're both there. And it seems on this -- maybe I'm being superficial but it seems -- on the surface, it seems unfair to have kind of your customer in the dock, but you're not there with them when they relied on your advice.
Mr. Tarbell: Well, we are there with them.
Ms. Walker: Yes.
Mr. Tarbell: We are exposed to their -- to their judgment and liability and ability to sue us.
I don't think it's unfair and I do think you're simplifying it with all due respect. The fact is that, yes, they hire us because we think -- they think we will give them a reasonable opinion of value. But that doesn't relieve them of their duty to investigate.
Just like -- I mean, ignore ESOPs. Think Delaware law -- right, corporate law. Right? A board of directors akin to a trustee is not relieved of its duty to investigate the advice it receives.
Mr. Hauser: I appreciate that. And so that -- let me just say a completely different question and maybe I'll just direct this to you, Ms. Walker.
But I -- I -- I understand the point about credentials and state regulation and licensing and all the rest when it comes to real estate appraisers. But can you identify -- are there any states, and I don't know the answer, I mean, are there any states right now that impose licensing, testing, sorts of requirements on people who appraise stock or who are in that business or limit their ability to practice based on any -- any conduct or qualification standards?
Ms. Walker: Well, for business valuations there is no state licensing. And we certainly don't advocate that. But, again, we think if you look to credentialed appraisers you will look at people who are both, you know, independent, competent, and accountable, which I think is what we're trying to get at.
Mr. Hauser: And are there any state laws that specifically, you know, purport to even provide remedies specifically for appraisers apart from, you know, for claims against appraisers, apart from kind of general negligence standards and the like that you can think of?
Ms. Walker: I don't --
Mr. Cook: Again, I don't know --
Ms. Walker: I don't know.
Mr. Hauser: Okay.
Mr. Cook: I'm also a CPA and have credentials, okay? My license with the state is that I must do -- do professional care and I cannot undertake any project or any engagement that I am not competent to do so. If I do and it is brought up, my license will be suspended or I will go to disciplinary action depending upon the severity of how I messed up.
Mr. Hauser: So, and that's a good point. Thank you. But if your license were taken away as a CPA and in the state you practice in, would you still be able to market yourself as an appraiser for stock?
Would any -- are you aware of any state law that would --
Mr. Cook: I'm not aware --
Mr. Hauser: -- prevent you from doing that?
Mr. Cook: I'm not aware of any. I'm not.
Mr. Hauser: Okay. Thank you.
Mr. Tarbell: Larry and I are both registered representatives under FINRA and while that is not directly a business valuation issue, you know, that organization as well as the Charter Financial Analyst Program, which I and Ms. Walker are a member of, and many ESOP appraisers are, and the ASA, have -- have -- you know, they're not toothless in enforcement.
There are -- and, in fact, most serious at FINRA, there are very serious regulations about customer complaints, about complaints to the organization regarding ethics and those are taken seriously and, you know, that's an important question the trustee should ask their appraiser. And I think they are eventually if finally, you know, adjudicated, they are a matter of public record.
Mr. Hauser: Thank you very much.
Ms. Borzi: Can I just ask one quick question?
Are you then required under those rules to -- when you sign your engagement letter to tell your customers they have the right to complain to FINRA?
Mr. Tarbell: We don't perform ESOP valuations as a broker/dealer. I don't know the answer to that. I mean, the answer must be no, because we don't and we don't do them as a broker/dealer. But even if we did, I don't -- I couldn't tell you the answer.
Mr. Piacentini: I guess I want to follow up just a little bit more on the question of sanctions within the profession and credentialing because it's not yet completely clear to me how public these sanctions are.
Ms. Walker, you said that a trustee could call up and find out whether somebody was still accredited. So I guess that goes to whether they've been expelled. But it sounds like that's not somehow posted publicly, they actually have to call up.
And are the lesser sanctions public information or not?
Ms. Walker: The lesser sanctions I don't believe are. But, again, I think -- I think it would - - I would hope a trustee would know. I guess if I was a trustee and I was hiring an appraiser I'd ask. I have been asked, you know, do you have any sanctions against you? Have you ever been -- you know, had any action against you by your professional organization?
So, you know, there is that kind of due diligence on the part of the trustee that I think can get to some of these sanctions and whether there's been any ethical violations on behalf of an appraiser.
Mr. Piacentini: That might be the trustee discharging their duty. But it's less clear whether they would always be told, I guess.
Are there examples of these kinds of sanctions that have occurred in ESOP cases, ESOP abuses? Do you know or --
Ms. Walker: I don't know.
Mr. Piacentini: Okay. Then I have a question for Mr. Cook. In questions for Ms. Borzi, you talked about an example where there were two valuations 18 percent apart. And you were asked to opine on which one was better. So -- and that was a termination.
Mr. Cook: That's correct.
Mr. Piacentini: So just so I'm clear so then what's going on in that transaction is the company's buying back the stock or...
Mr. Cook: Yes.
Mr. Piacentini: Okay. And then I guess my last question for anybody on the panel, for the first panel, I gave an example of some academic research that had found that appraisers who are, you know, told sort of in an experimental setting that they're conducting a valuation on behalf of a buyer come to a value at least in this particular study, came to a value that was only a little more than half of the value that people who were told they were performing this valuation for a seller.
Have you seen research in this area as this - - is there a view you have on what we should think about, about that sort of thing?
Mr. Tarbell: I'm not familiar with the study and I haven't seen research in the -- on the topic so I can't address the study. But -- but there was a fundamental premise and I think, you know, I know some of the previous participants on the previous panel for about 20 years. I was -- I will posit that they share this view even if they didn't comment on your comment earlier, which is that value depends upon your client and who hired you.
Not in our world as ASAs, not when we are asked to determine fair market value. That is -- you know, I couldn't disagree with anything stronger. It doesn't -- it is -- and that -- you know, that's a fundamental problem here where some of the disagreement is is that we're -- our task, as we've been trained to do, is to determine value from an independent, unbiased perspective without identification of -- or assumption of the identity of a willing buyer -- of the buyer or seller, right there, hypothetical parties, yet, there's this statement that a fiduciary acts in the best interest of a plan participant. And it's very hard to reconcile those two statements.
Mr. Piacentini: May I make a request of you all and that's that obviously who knows what's going to be in the final regulation, but it seems to me if we were to include appraisers, you're going to want us to say something on this point about independence and partiality, scope of the engagement and the like. And it would be very helpful if you could give us a comment on what you'd like that language to look like if it came to that.
Mr. Tarbell: And, you know, I don't know that there's any effect of me saying this, but I think to the extent that you're considering putting in provisions like that, it would also be very helpful for us to see those regs and have a chance to comment on them before they're issued final.
Mr. Piacentini: I have nothing else.
Mr. Davis: Thanks, Panel 9.
We went a little longer than scheduled, but we wanted to make sure we got all the questions out. It was a spirited dialogue and we appreciate it.
Thank you very much.
We'll move right into Panel 10. And after lunch, we'll try to get back on schedule. But if Panel 10 can come up.
Panel 10 we have Mr. Hardock with Davis and Harman, Mr. Kaswell, with the Managed Funds Association and Mr. Anderson with the Retirement Industry Trust Association.
We'll start with Mr. Hardock.
Mr. Hardock: Thanks. I'm Randy Hardock. I'm a partner at Davis and Harman. Our firm represents numerous large financial institutions including insurance companies, mutual fund companies, brokerage firms and banks.
I appreciate the opportunity so speak with you today.
For the almost 50 million U.S. households with an IRA it's imperative that the Department's proposed changes to the investment fiduciary definition be successfully coordinated with the SEC review of the appropriate standard of care or standard of conduct applicable to broker/dealers providing investment advice to retail customers and including especially IRAs.
I'm not going to focus on substance, on what the DOL and SEC should be doing, but rather on the process for jointly getting to the correct answer, the best answer for participants.
The bad news I think is that on the 10th Panel of the second day, I, and probably you, feel that everything has been -- that can be said already has been said, just not by me. The good news for me is that every question that you probably have has already been asked and answered, just not by me. So I'll recap a little bit of what I heard yesterday and I hope you heard also and briefly give you our perspective.
First a few of the points that were raised, really by multiple witnesses yesterday and in multiple comment letters.
I start with IRAs are different. They are not ERISA plans. They are regulated in large measure by the Internal Revenue Code, with the Internal Revenue Code Prohibited Transaction Rules and Internal Revenue Code penalties, ultimately enforced by the Internal Revenue Service. You have great responsibility there, but the IRS also is involved.
IRAs also exist in a very different environment from employment-based retirement plans, but generally a retail environment without the involvement of an employer.
We also learned yesterday and you already know this, that there is very little analysis that has been done on the costs of the DOL's proposed changes in the IRA world, costs that could ultimately, almost certainly will ultimately, be passed through to consumers.
Witnesses also noted that an integral part of the ongoing congressionally mandated SEC review of the standard of care that should be applied to brokers and dealers, including specifically whether brokers and dealers should be treated as fiduciaries includes the IRA world and IRAs specifically.
We heard that the SEC and the DOL projects were interrelated, that they overlapped at least at some level. And we heard that the DOL and the SEC projects had the potential to conflict in substantial ways and thereby potentially impede the provision of investment assistance to individuals and cause widespread disruption of IRA providers and the way they provide services, particularly in the commission-based environment.
There was considerable discussion of how exactly the department and the SEC should interact. I think somewhat tongue-in-cheek, Phyllis, you said should the DOL just roll over and follow the SEC lead? Obviously, not.
But the two government agencies do need to work together and the words are "coordinate" or "consult" or "harmonize." I don't really know the difference between those words. I think certainly there is a consensus that the agencies need to work together and that they would work together. So we agree with that approach.
But I'm also, you know, living in the real world and I know that everyone over there who has ever worked on a cross-agency project knows just how painful that can be. The other agencies don't always agree with you and that's a difficult process.
All too often when agencies say they're coordinating, they basically go in, having made up their minds on what they think the right answer is and then -- and then argue about it and try and beat the other agency into submission.
So we urge you in this context not to go in and to actually work with the SEC. This is really an opportunity to do that and to get to a better answer for everybody in the case of IRAs, because any other approach in this world -- in the IRA world could be very dangerous.
SEC and DOL should not craft their own rules in advance, get their feet set in stone and then get together at the end of the process and look for direct conflicts. That is not going to be the best approach for consumers. As one of the witnesses said yesterday, I'll paraphrase him, what ends up happening in that world is you may get dual standards and the good guys incur the costs, the good guys follow the rules and the bad guys don't in the IRA world.
Rather we urge you to follow the principles laid out in the President's recent Executive Order which requires active coordination, not simply notifying other agencies of pending projects. The Executive Order is very critical of regulatory requirements that are inconsistent or overlapping and requires agencies to attempt to promote coordination, simplification and harmonization.
Consistent with that direction from the President, the Department and the SEC should start working together now towards a clear single standard fairness opinions conduct for broker/dealers providing investment assistance to consumers.
This does not mean the Department rolls over and does what the SEC says or vice-versa. Rather, the agencies should work together from the outset in a mutual effort to create a single consistent and clear set of rules applicable to brokers and dealers assisting customers with their IRAs.
Yes, the fiduciary and transaction rules applicable to IRAs and the securities laws are different. They have different objectives and both the SEC and the Department have their own responsibilities with respect to those statutes. But the benefits of a consistent rule from our perspective -- given the consumer are significant and that needs to be the goal.
In concluding that the same standard of care should apply uniformly to both broker/dealers and investment advisers, the SEC staff study concluded that different standards of care served to confuse retail customers and the consistent standards would increase consumer protection. That's what's needed in the IRA space, a single consistent standard.
The Department has the authority to achieve that objective through the fiduciary definition or through prohibited transaction class exemptions.
Tim, you asked yesterday whether all of the problems or many of the problems that were raised could be dealt with by changing or tweaking the existing prohibited transaction exemptions or providing new ones. I think the answer may well be yes, but you haven't done so. And that is obviously a great concern when you're dealing with potentially massive disruptions in the way business has always been done. Disruptions that you may well not intend.
So those PT exemptions are critical and must be adopted and considered concurrently with any changes in the investment fiduciary definitions in order to avoid that unnecessary disruption, particularly in the IRA space. You've done that in the past with PT exemptions associated with regulations and it is completely appropriate in the case of major changes like those you're dealing with right now.
And just as changes with the DOL's investment fiduciary definition should be coordinated and harmonized with the SEC standards, appropriate PT exemptions should to the extent possible be harmonized.
Once again, we appreciate that it's difficult to reach that consensus opinion and that it could take time. It also may lead you to conclude that it may make sense to break out these non-ERISA plans from other issues addressed in the proposed investment fiduciary regulations, as you did for welfare benefit plans under 408(b)(2), and now that project is ongoing in that context.
But it doesn't, once again, mean that the Department should step aside and just wait to see what the SEC does. It doesn't have to mean that. Actually, a dialogue starting right now between the DOL and the SEC and I caution to say this, I dare to say this to all of you, but the Treasury and the IRS folks who are going to be responsible for enforcing this regime in the IRA PT rules, those agencies should, consistent with the President's Executive Order, agree at the outset that the goal should be to work to arrive at a single standard for broker/dealer's interacting with retail customers in the IRA space.
As I said, that single standard if properly implemented and enforced consistently by the SEC and the IRS, would be in the best interest of IRA participants.
Mr. Davis: Thank you.
Mr. Kaswell: Thank you. My name is Stuart Kaswell and I am general counsel for the Managed Funds Association.
MFA is pleased to provide the statement in connection with the Department of Labor's hearing on the proposed definition of the term fiduciary under the Employee Retirement Income Security Act.
MFA represents professionals who manage and advise hedge funds, funds of funds, and manage future's funds as well as industry service providers.
MFA's members manage a substantial portion of the approximately $1.9 trillion invested in absolute return strategies around the world.
MFA strongly supports the Department's goal of protecting benefit plans and their participants and we recognize that imposing fiduciary status in certain circumstances is important to achieve that goal. We also support the Department's efforts to examine its existing rules to see if they have become outdated.
Our concern, however, that the Department's proposed definition of fiduciary may be broader than intended. And it inadvertently could capture many market participants that Congress and the Department previously have explicitly determined should not be fiduciaries under ERISA.
Each of the issues discussed in my testimony today are also addressed in MFA's February 3rd comment letter.
Before discussing the specifics of the Department's proposed rules, it is important to note that hedge funds and other alternative investment vehicles are a valuable component of the investment portfolio for sophisticated investors including pension plans. The properly managed addition of hedge funds to a portfolio -- sorry -- provides diversification, risk management and returns that are not correlated to traditional equity and fixed income markets. These are critical benefits that help plans generate sufficient returns to meet their obligations.
The value that hedge funds add to plan portfolios is demonstrated through the significant investments made by plans and endowments in hedge funds. Plans and endowments in every state invest in hedge funds because of the benefits to their investment portfolios.
The proposed rule may make a broad range of entities fiduciaries for purposes of ERISA, including the general partner and adviser to a fund that does not hold plan assets under ERISA and persons providing valuation services to such non-plan asset funds.
While it is clear whether -- while it is unclear whether the Department intended to include such parties within the scope of the proposed rule, we respectfully submit that such an interpretation would be inconsistent with a clear Congressional mandate that such entities should not be fiduciaries under ERISA.
Congress most recently spoke to this issue when it enacted the Pension Protection Act of 2006, which added section 342 of ERISA. Section 3(42) states, as you know, the assets of any entity shall not be treated as plan assets if immediately after the most recent acquisition of any equity interest in the entity, less than 25 percent of the total value of each class of equity interest in the entity is held by benefit plan investors.
The statutory language and the Department's rules clearly demonstrate that advisers and service providers to non-plan asset funds are not fiduciaries under ERISA.
Because the language in the proposed rule is drafted so broadly, we are concerned that it could be interpreted in a way that is inconsistent with the plain language of ERISA as well as with the Department's own rules and guidance with respect to non-plan asset funds.
Accordingly, we urge the Department to make clear in any final rule that nothing in the rule will cause a general partner, adviser or service provider to a non-plan asset fund to become a fiduciary because of any statement, report or recommendation regarding the value of the non-plan asset fund or any of its assets.
We also are concerned that the proposed rule could make the general partner or adviser to a plan asset fund a fiduciary to plan investors simply because the plan asset fund sends periodic reports to fund investors. Such an interpretation would create uncertainty as to whether the fees charged by an adviser could violate the prohibited transaction provisions of ERISA. As a result, managers may not provide comprehensive information to plan investors.
Each of the service providers or counterparties that provide information regarding the value of an asset also could be a fiduciary under the proposed rule, which could invalidate their asset-based fee compensation. Faced with potentially prohibitive costs or the inability to find suitable service providers, funds may be reluctant to take investments from ERISA plans which would greatly limit plans' alternative investment options.
We urge the Department to consider a more narrowly tailored approach with respect to determining which persons involved with the valuation of assets of a plan fund, asset fund should be considered fiduciaries.
Turning to other topics, we are concerned that the selling exception may not adequately cover the marketing activities of pooled investment funds. We recommend that the Department revise the exception to cover the selling of services and investment products by a fund or its adviser to a new and existing investor. A fund's marketing activity should not by itself create a fiduciary relationship.
Further, the proposed rule requires that the seller warn the plan that its interests are adverse. We urge the Department to delete the term "adverse." In our view, it should be sufficient if a seller makes clear that it is providing marketing services and not impartial investment advice. We would have no objection requiring marketers to state when they have a financial interest in the outcome.
The selling exception also should make clear that it covers counter-parties and swaps and other lending credit arrangements. Finally, it should cover contractual rights and the exercise of those rights. Without appropriate exceptions fund counter-parties may refuse to deal with any fund -- any plan asset fund because the risk that the counter-party could be deemed a fiduciary.
The proposed rule also changes three wellunderstood tests for determining fiduciary status which remove uncertainty and clarity from the definition.
First is mutual understanding. We believe the rule should be based on both parties' understanding when a person becomes a fiduciary, as under current law. Eliminating the term "mutual" creates uncertainty whether a plan could elect on its own to make another person a fiduciary.
We respectfully urge the Department to reinstate the term "mutual."
Second, may be considered. Another change is that advice does not need to be a primary basis for a plan's decisions. A person may become a fiduciary if the advice may be considered in the plan's investment decision.
We respectfully submit that this formulation is overly broad and could apply to all information conveyed to the plan. The proposed rule would create significant uncertainty and potentially broad liability for market participants.
The Preamble to the proposed rule states that the rule is intended to capture persons who significantly influence the decision of plan fiduciaries and have a considerable impact on plan investment. We urge the Department to use that standard, "significantly influence" rather than may be considered in the test for when advice should be deemed fiduciary advice.
Third, tailored advice. Under the proposal, public recommendations such as information provided at conferences and publicly available research materials may be deemed fiduciary advice regardless of the forum and even if the recommendations are not tailored to a particular plan. While the Department may have not intended this far-reaching result, the proposal creates uncertainty as to the scope of recommendations that will be deemed fiduciary advice.
Accordingly, we urge the Department to amend this part of the proposed rule.
We also are concerned that the definition of fees in the proposed rule could be interpreted to require aggregating many unrelated transactions resulting in fiduciary status for unwitting service providers. It is critical for market participants to fully understand the scope of this new definition.
Accordingly, we encourage the Department to provide guidance on the intended scope of the definition and to allow a further period for public comment.
MFA appreciates the opportunity to testify before the Department. We hope to play a constructive role in shaping any changes to the scope of the fiduciary status rules.
I'd be pleased to try to answer any questions.
Mr. Davis: Thank you, Mr. Kaswell.
Mr. Anderson: Good morning. My name is Tom Anderson. I'm the vice chairman and founder of the Pensco Trust Company and president of the Retirement Industry Trust Association who I reference as RITA.
The good news is that we're near the end of this hearing for you. The bad news is I'm going to be adding to the litany of concerns, however, the good news there is I have fewer concerns than some of the others because of the nature of our business.
I do appreciate the opportunity to testify on behalf of our organization. We are a nonprofit national trade group consisting of federally and state registered banks and trust departments or trust companies and we administer approximately 400,000 retirement accounts with approximately $55 billion in retirement assets.
RITA members generally act as directed custodians or non-discretionary trustees of selfdirected IRAs and individual pension plans like 401(k)s for sole providers.
These plans generally hold alternative assets including real estate, private equity, private debt, real estate being foreign, domestic, and many other alternative assets that are permitted under the Internal Revenue Code. We also include traditional assets such as stocks and mutual funds.
Unlike the majority of the nation's IRA administrators and custodians, we don't channel or limit the choices of the clients' investments. The client can be the fiduciary and usually is, along with another selected fiduciary like an adviser, directs us to acquire whatever assets that are permitted under the law.
In that sense and by virtue of the facts that we provide no investment advice and we sell no investment products, but for some of the provisions under the proposed regulations, we are about as far from being fiduciaries as most of the people who testified here in the last two days.
However, because of certain elements within the Department's proposal, we will indicate our objections, which we believe could potentially be harmful to not only us but the Americans that we serve.
In short, there are three problematic elements in the Department's proposal that resulted in our wanting to be here to testify.
First, we do not believe self-directed custodians and trustees should be deemed fiduciaries merely for reporting assets and their values determined by other third parties as implied in the current proposal.
We do believe that we should be able to provide helpful information to participants and IRA owners on the rules, tax consequences and mechanics of both discretionary and mandatory distributions. We think, in fact, that's our duty as -- under our service agreements.
And, lastly, we believe that IRA custodians should be granted the same exemption from being considered investment advice, that is the provision of educational material and a platform for the distribution of mutual funds and other securities as granted defined contribution plan administrators.
To support our position, RITA members have never been deemed fiduciaries heretofore. RITA is not hiding behind our disclosures but being judged by our contractual obligations and our actions. RITA members do not give investment advice. Consequently, we do not contract nor charge for something that we don't provide. We also do not sell investment products nor do we have any business relationships with ASA sponsors or advisers. We do not determine the value of assets we hold as self-directed custodians. It is the fiduciary's responsibility to obtain the value and to - - and we report on that after we receive it from them.
Custodians are, however, subject to certain reporting obligations under the Internal Revenue Code. Most notably custodians of IRAs must provide annual evaluations in order to comply with reporting requirements of the Code. In doing so, self-directed custodians report values that are provided by third parties such as investment providers and investment managers who in turn may rely on professional valuation or appraisal firms.
Furthermore, self-directed custodians do not have the legal authority to demand from investment sponsors the information that would be required to independently perform valuations on alternative assets. I think it is both infeasible and unrealistic to assign responsibility when the authority to execute it is neither existent or granted in conjunction with that responsibility.
As stated by several parties yesterday, the mere act of passing through the value of an asset determined by someone else should not be considered a fiduciary act even in conjunction with a distribution event. In addition, we feel it is axiomatic that a person without discretionary authority is not acting as fiduciary. In fact, the very notion of extending fiduciary status to self-directed custodians is at odds with ERISA's functional definition of a fiduciary.
A person is a fiduciary only to the extent that that person is performing a fiduciary function and the mere transmittal of valuation information is not a fiduciary function.
Similarly, one can fairly characterize the role custodians serve satisfying the reporting obligations of the Code as a mere ministerial role, which again is a type of a role that ERISA clearly views as non-fiduciary.
I would also like to at this point agree with my colleague over here that we're talking IRAs here for the most part or non-ERISA pension plans. So there's even more of a reason to divide the issue.
As clarification on this point to eliminate fiduciary status for mere reporters of asset values is critical to ensuring the ongoing viability of selfdirected IRAs and retirement plans. I think all of us in the industry appreciate the Department's efforts and that of other regulators to raise the bar, if you will, to avoid the next Bernie Madoff. But let's all be clear here Bernie was a fiduciary and the imposition of new regulations wouldn't have helped. And, basically, the enforcement of the existing regulations were -- was needed. It would have helped immensely.
The moral here is the imposition of new regulations has to be carefully thought through so the intended consequences achieved in a manner that is cost-effective overall for the intended beneficiary, the consumer. Put another way, if we end up through additional regulation to pass on more net expense to the retirement system and savers that we serve, we have missed the mark.
To demonstrate how easy that is, and in all deference to Ms. Borzi, I have to be honest and admit that I did unintentionally consume a small amount of foie gras last evening when I -- when I intentionally ordered the chestnut soup at Marcel's without having read the small print.
So I think while the five points that are -- exist in the 1975 Code for exceptions, are maybe subject to some consideration for change, I think the one thing that's good about those five points is they're understandable and digestible and you can, much like IRC 4975, you can maintain compliance with them.
But seriously, I'd like to say that we concur with many of the previous speakers as follows:
The proposal appears well intentioned but has the potential to have negative consequences that could far outweigh the intended benefits.
Expanded rules and regulations could result in inefficiencies, unnecessary litigation, loss of services and higher costs.
The proposal, if not harmonized with that of the other regulators, could result in the development of overlapping and conflicting regulation between regulators which is likely to do nothing more than add more legal expense and litigation.
We agree with the Department, we agree with the Department that entities should not hide behind their disclosures. I for one believe that actions, not words of disclosures, speak louder than such words and I believe case law substantiates that the courts do as well. In other words, if it walks and quacks like a duck, it is a duck despite what it quacks to the contrary.
As stated yesterday, fiduciary status should be based on the actual nature of the advice provided and not what is said about the advice in terms of what -- what it might be -- might be when it is provided.
To conclude for us, imposing a fiduciary status on custodians would also not serve the policy concern that is motivating the Department. Directed custodians do not operate under any conflict of interest nor are they in a position to exert any influence over plan decisions. When they furnish plan reports to satisfy tax law requirements the custodian is merely complying with the -- sorry, supplying the information provided by third parties.
Unfortunately, the potential imposition of fiduciary status could have enormous consequences. IRAs hold more than 4 trillion in retirement assets which represents more than one-quarter of all U.S. retirement wealth. It is critically important that directed custodians continue to offer cost-effective administrative services to millions of Americans diligently saving for retirement.
Custodians do not currently carry fiduciary insurance and more than likely would be unable to obtain it even at a high cost. Some custodians could exit the industry leaving fewer providers to administer retirement plans and at higher cost to consumers. This in turn could result in fewer investment choices for retirement savers, less investment diversification and therefore, higher investment risk for American savers.
In conclusion, for the reasons discussed above, we urge the Department to modify the final regulation to explicitly provide that the custodians who furnish valuations or do value assets prepared by third parties on plan reports are not investment fiduciaries. The absence of such a clarification would have enormous implications for our industry, the clients we serve and the retirement system.
Thank you for consideration and we're open to any questions.
Mr. Davis: Thank you.
Ms. Borzi: Well, notwithstanding the fact that your Panel 10, I think you -- I want to thank you for your valuable contribution to these hearings. And everyone will be relieved to know that I have a -- just a few things that I want to say and then I'm going to disappear.
And for those of you who are of the panels this afternoon, you will probably be even more relieved to discover that I'm not going to be here this afternoon because I'll be with the Secretary at the PBGC Board Meeting.
So really, there are just -- there's just really one thing that I want to say and I want to reiterate it for the people who weren't here yesterday. Randy, we're not going to take your advice to begin to coordinate now, because actually we've been trying to work with the other agencies and have been working with the other agencies for quite a while because we think it -- we thought that this was very important. We worked with the SEC, with the CFTC, from prior to the enactment of Dodd/Frank and, of course, we have a longstanding relationship with the IRS.
I am completely mindful because both of us had prior lives, about the difficulty of working together. And that's why yesterday I made it quite clear that what we're trying to do is harmonize these rules, and that's our goal and objective. Not just -- and the reason I engaged in that dialogue with Steve Saxon yesterday was because on one of the earlier panels we were admonished that coordination wasn't good enough. That if coordination meant just talking to each other and telling each other what we're doing that that wasn't good enough. And there isn't anything that I agree with more than that.
So let me also repeat something that I said yesterday and I feel very strongly about, we have no intention and there's no mileage for us, to increase the cost to the regulated community by having you have to comply with multiple and conflicting standards. Having been in this business for too many years than I care to count, certainly since the passage of ERISA, I've seen both in the public sector and the private but in the government and the private sector, I've seen the destructive and counter-productive impact of conflicting rules and regulations. And if there's one thing that I'm determined to avoid it's that.
So you should -- nobody should have any doubt of our desire to avoid all the concerns that you and the prior panelists have exhibited. Is it going to be easy t try to reconcile these things? Probably not. But are we committed to doing it, the answer is absolutely, yes.
But I can't resist pointing out one thing and you were in the audience yesterday I think when I -- when I responded to this as well. There is not -- we cannot guarantee, given the fact that we have multiple legal regimes here, that broker/dealers will have a single standard. And that was the nature of my question yesterday, because I was a bit confused about some of the testimony.
Yesterday, a lot of people talked about it and you referred to it as well, the SEC study of broker -- that was required in Dodd/Frank. And people tend to talk about how there needs to be a uniform federal standard as if that had a much broader direction from Congress for application. You correctly stated that this uniform Federal standard that Congress directed the SEC to study was under the securities laws and it had to do with whether the standards that currently apply to investment advisers should advise -- should expand -- be expanded to broker/dealers.
But certainly there's no implication and one should take none from Congress' direction to the SEC to look at that, that that in any way means that our ERISA standard which is a higher fiduciary standard than that in the securities law needs to be subrogated to that, if you will.
So as -- building on what Alan observed before, in my mind, the project that we're engaged in, the mutual dialogue that we're engaged in and the -- it's all about three things. It's about accountability, it's about transparency, and it's about conflicts of interest.
And my hope, my goal, is not just that we will try to harmonize the potential conflict in these other statutes but that we will continue to work with all of you in the regulated community. I heard some very important things over these past two days and surely agree with at least some fairness opinions them.
And to the extent that we can address them and work cooperatively we're going to. That will be our goal. So with that, I'll stop and have my colleague here ask his questions.
Mr. Davis: I have no questions. I can't top that. I'll pass it on to Alan.
Mr. Lebowitz: None from me. Thanks for your thoughtful comments.
Mr. Piacentini: I guess I have just one question for Mr. Hardock. In terms of IRAs being different, I will note that there are some IRAs that are also ERISA plans and for that purpose, do they go in the bucket with the plans or in the bucket with IRAs or in a third bucket or why?
Mr. Hardock: I think as a -- I think I started saying I was going to talk about process and not substance. I think they are in a third bucket. You clearly have different factors there and you would need to have that be part of the process.
And as Phyllis indicated, you have responsibilities not only there but in interpretative - - or in the allocated responsibility in the IRA space. So, but I do think there are different factors that would have to be taken into account there.
Mr. Piacentini: Thanks.
Mr. Wong: I just have one question. This is for Mr. Kaswell. In talking about plan asset vehicles, he seemed to express concern that with respect to a plan asset vehicle, when the general partner sends out a statement to its investors reflecting the value that that would be considered fiduciary in nature under the proposal.
So my question is: Under current law would you view that fiduciary -- that valuation of the plan asset vehicles assets as being fiduciary in nature in and of itself just because it's a plan asset vehicle?
Mr. Kaswell: Well, I think with respect -- certainly with respect to the investment adviser's act that the advisers to the fund is a fiduciary and to the securities law. Now, I understand I'm sitting in the Department of Labor not at the SEC and I get it. But the responsibilities of the -- of the adviser in that setting are formidable.
There are very strong incentives to get it right and we know that if we don't get it right, bad things can happen. That if you set it too low because fees for investment managers are linked to the -- how well the fund does you've hurt yourself. If you set it too high and somebody's redeeming, you're going to bail out somebody, you're going to pay out somebody at a higher rate and penalize the rest of the -- the rest of the advisers -- the rest of the investors, excuse me.
So we think that there are strong incentives for an adviser to get that right and to make sure that the -- the assessment -- the analysis on the evaluation is as correct as they can make it and also want to be able to go to outside parties if we're not sure we have the expertise internally, the manager, that is, so that it can say well, we think for most of these assets we can do it but we want to get some outside advice to validate our own analysis. We want to make sure that all of those things remain open.
Mr. Wong: And just -- so I'm making sure I fully understand your response. We are talking about a plan asset vehicle that has greater than 25 percent benefit for an investor and doesn't meet one of the exceptions in the current plan asset regulation?
Mr. Kaswell: Right.
Mr. Wong: Is that correct?
Mr. Kaswell: Yeah. I must admit that since I am not an ERISA lawyer, I can get lost in this. And so if we need to clarify for the record I'm happy to do that.
Mr. Wong: Okay. We'll clarify that. Just please feel free to do so.
Mr. Kaswell: Sure.
Mr. Davis: Thanks, Panel 10. Thanks for your time. Very helpful comments. We're going to adjourn lunch and reconvene on time at 1:15. So we'll see you in just about an hour.
Mr. Davis: If the members of Panel 11 could approach the stage, take your seats. We have Mark Smith with the Financial Services Institute: John Watts and Peter Schneider; Primerica and Brian Tate with the Financial Services Roundtable.
Okay, Panel 11, we'll start with Mark Smith.
Mr. Smith: Good second afternoon of the hearing. I am Mark Smith from the Sutherland Law Firm. And I'm testifying today on behalf of the Financial Services Institute or FSI. My testimony focuses on the impact of the proposed definition of fiduciary on plan participants and IRA owners who obtain investment services through independent broker/dealers.
FSI is a policy and advocacy organization for independent broker/dealers and independent registered representatives. In the U.S., approximately 201,000 registered representatives operate as self-employed independent contractors of independent broker/dealers rather than employees of an affiliated broker/dealer firm.
Independent broker/dealers primarily engage in the sale of packaged products, such as mutual funds and variable insurance products to invest individual investors in retirement plans and have been an important part of the retirement savings community for more than 30 years.
Independent broker/dealers and their representatives are especially well suited to provide middle-class Americans with the investment products and services necessary to achieve their retirement security and other financial objectives and goals.
The proposed redefinition of fiduciary is without question among the most consequential ERISA rulemakings the Department could undertake. The existing regulatory definition of investment advised fiduciary promulgated in 1975, just after the enactment of ERISA has informed 35 years of practice for employee benefit plans and providers of investment services to those plans.
While FSI addressed a number of issues in our comment letter, our principal point today is that the financial services industry in the main is not and cannot be organized as ERISA fiduciaries. I should emphasize that this is not because FSI's members see their interest as adverse to those of plan participants or other investors. The objective and aspiration of independent broker/dealers is to serve the best interest of their customers and FSI supports, for example, a harmonized securities law standard for broker/dealers and investment advisers that promotes investor interest and choice, transparency, low cost investment products and services and the avoidance of conflicts.
And having noted that, I do feel obliged to note that FSI's written comment letter did not exhort the Department to harmonize with other agencies given our absolute confidence that the responsible agencies already were actively and constructively engaged in that process in a manner that will be a credit to all at the end of the day.
Mr. Davis: Thanks, Mark.
Mr. Smith: You're most welcome.
Instead, our concern reflects the reality that financial services companies sell investment products and services. Specifically, independent broker/dealers and their registered representatives provide highly regulated professional investment services to investors in accordance with standards of conduct specified by the SEC, FINRA, State Insurance Commissioners and other regulators in addition to the Department. Most often, they are lawfully compensated on a commission basis, a form of compensation allowed service providers under ERISA but not investment advice fiduciaries as the Department interprets the statute.
Over the last 35 years, the Department has devoted significant resources to building a regulatory structure that makes it possible for broker/dealers to continue their important services for plans and their participants and necessarily so.
The investment services provided by broker/dealers are both exclusively available for them in many cases as a matter of federal and state law and integral to the purposes of ERISA plans.
The requirements of this regulatory structure turn in many instances on whether the broker/dealer is or is not acting as an investment advice fiduciary for the plan. Since independent broker/dealer firms are most fundamentally selling firms, doing business in the ordinary course on a commission basis inconsistent with the requirements for ERISA fiduciaries, a distinction between non-fiduciary and fiduciary activity is sensible both in the marketplace at law. And whatever its perceived faults, the current five part regulatory test for investment advice fiduciary status provides a reasonably reliable way for independent broker/dealers to structure their relationship with the plan on either a fiduciary or non-fiduciary basis as appropriate to the circumstances.
FSI's concerned that the Department's proposed redefinition of fiduciary status upsets this carefully crafted and balanced regulatory structure. The proposed replacement of the five-part test with the new multi-factor test would substantially prevent a broker/dealer in a plan from purposefully and reliably arranging their relationship on a non-fiduciary basis.
It may even be that ordinary broker/dealer sales activity incidental to securities transactions would be treated as investment advice under the proposed multi-factor test.
Moreover, the new excerptors in the proposed in the proposed regulation as drafted, neither provide a reliable means for a plan and a broker/dealer to avoid fiduciary status when that status is both unintended and unwarranted, nor reflect a distinction under ERISA between marketing and fiduciary activity recognized by the courts.
In short, the -- in our judgment, the proposal threatens to undo 35 years of work by the Department to assure that the necessary investment services provided by securities firms remain available on viable terms to ERISA plans.
Also, there are entirely legitimate business reasons for financial services firms to limit their activities to plans to non-fiduciary services. The incremental risks and costs of acting as an ERISA fiduciary is, for many firms, beyond the prudent reach of their resources. If the final regulation does not provide a clear path to avoid fiduciary status where appropriate, these firms will be driven out of the retirement market by regulatory uncertainty rather than for any reason on the merits which is not to the benefit of plans, their participants or our capital markets.
Given the detriment to plans and their participants of leaving these issues unaddressed, we respectfully submit that any final regulation must unambiguously provide a means for broker/dealers to continue in the ordinary course to provide their necessary services to plans other than as ERISA fiduciaries.
This might be accomplished in a variety of ways, which are outlined in FSI's comment letter to the Department. They might include providing a specific exemption crafted for broker/dealers or reframing the selling exception to cover investment intermediaries who state in writing that they are not undertaking to act as fiduciaries in the manner required by ERISA.
I should also comment on the potentially profound impact of the proposed redefinition on IRA owners who work with independent broker/dealers. We share the view you have heard from many others that the proposal would have the unintended consequence of constraining both the choices of IRA owners and the availability of commission-based products and services in a manner that may increase costs and reduce retirement savings.
Accordingly, we concur that in light of the fundamental structural differences between ERISA plans and IRAs, the Department should consider whether the appropriate scope of fiduciary status should be different for IRAs and Title I plans.
Finally, I should also note that while we did not cover this point in FSI's written comments, we have come to the conclusion that it would not be possible to meet the 100-day -- 180 days after publication effective date in the proposal. If the final regulation necessitates either any meaningful analysis of or any adjustments to the millions of relationships independent broker/dealers have with ERISA plans and IRAs, no less than l2 months would be required.
We didn't want you all to think just cause we hadn't commented on it we didn't care.
This concludes FSI's testimony. We appreciate the opportunity to testify today and welcome the opportunity to answer your questions and work with the Department on this important regulation.
Mr. Davis: Thanks so much, Mr. Smith.
Now, Mr. Watts and Mr. Schneider.
Mr. Schneider: Yes. Peter Schneider. I'm the general counsel, executive vice president of Primerica.
On my right is John Watts who's the chief counsel of our broker/dealer.
We very much appreciate the opportunity to discuss the proposed rule with you and we very much want to work with the Department to try and craft the rule if there's going to be a change in a way that allows companies like ours to function.
And what I thought I'd do is tell you a little bit about Primerica, because Primerica's very a interesting company but I think more importantly, we operate in a marketplace, in an IRA marketplace that I'm not sure you've heard a lot about. So I'd like to start there.
So, Primerica is -- we have an insurance company, we have a broker/dealer, which is what's relevant here, and we will also do a loan for a client.
The households that we go into are distinctly middle market households. So our clientele is going to earn between $30,000 a year and $100,000 a year. They way I like to characterize our client is if you go into a Wal-Mart you're going to see our client. If you go into a Target you're going to see our client. They're probably not going to be in Neiman Marcus and they're probably not going to be in Family Dollar. So that's where our clientele is going to be.
And we have tremendous diversity among our client base and they have extraordinary needs that frankly, are not met at all by the traditional broker/dealers, because the small account, the small investor, the investor that does not have a huge nest egg of money to invest, has not been where the traditional industry is focused for the simple reason that the transition sizes tend to be very small.
So what a Primerica rep does, and we have a lot of them, so, we have about 20,000 Primerica representatives, I think it might make us the largest broker/dealer in the country by number of reps, we will knock on doors that no one's knocking on.
And let me tell you what we do. First of all, we knock on the door. So we're going to go into a household that has probably never met with someone in the financial services industry and we're going to sit down at their kitchen table, we're going to help them understand their needs. We're going to talk to them about death protection and that's our insurance product.
We're going to talk to them about how to manage debt. What we would say in our market, the saying we have, is they have "too much month at the end of the money." So they always have debt. And they are very unlikely to have any savings.
So, anecdotally, we looked at what we find when we come into a household with respect to an IRA. And out of 25 homes that we go into and sit across from those families, about 5 are going to have any IRA at all and they're very likely to be unfunded.
And so what's our goal? Our goal is to take that family and first of all, give them a financial education. So I did bring some materials, which I can pass out. I don't know if we're supposed to be distributing things our not, but we have something called How Money Works, which takes them through -- it's a very good document. It takes them through financial education. We have little brochures about IRAs 'cause our clients probably don't know a lot about IRAs.
And what we want them to do -- if we do our job, we go into this household and we do our job, they're going to have debt protection, they're going to have a better understanding of their debt. We can't always help them with that, especially with the current lending environment, although we only did fixed rate loans, never variable mortgages. And we only do, by the way, term insurance. We don't believe in whole life insurance for our market. We will pay this year about a billion dollars in death claims to middle market personnel.
But focusing on, I think, what you care about is the IRA. So about almost 60 percent of all the accounts we open are IRAs. Around 56, 57 percent are IRAs.
And what we want that family to do is to put money aside for retirement. We'll also, by the way, we also carry 529 college savings plans. So we're looking at save for college, save for retirement. But the main thing is save. Because in this market with our clients, the biggest competition we have is not broker/dealers, not ERISA plans -- a lot of the folks in our market don't have employers who are going to provide them with 401(k)s.
The biggest competition we have and I'm not being facetious is American Idol, because if we were not in that home helping that family, they're going to get distracted by all the things we all get distracted with in life and they're not going to put money aside.
So our goal is to start them savings. And so we'll take what we do what's called "pre-authorized checking" so we'll set up a monthly debit to a checking account that will then go into an IRA. And we'll do $50, we'll do $100. You know, these are not huge accounts but you have to start somewhere. And over time, these accounts accumulate a fair amount of money, although, they're still very modest when you compare them to other broker/dealers.
We also have though, just like everyone else, we have a fixed cost infrastructure. So we have to have websites, we have to have a platform, we have to send out account statements, we have to pay a representative to go into that home. We have to have compliance and we have to have legal; all of that exists.
And, by the way, you have to do that for a small account and you have to do that for a big account. The difference is the big account can easily afford those costs; the smaller account it's much more challenging.
And the fear that we really have with the Department of Labor's proposal is this: We can't figure out how that can work economically in a marketplace like ours. What we do know is how the current market works. The broker/dealer model that we deal with day in and day out works. It's able to provide enough revenue, a commission to a representative for opening an account. It's able to help us defray our infrastructure. It helps us service a client.
But if the prohibited transaction rule, if this applies to us, if we become a fiduciary for what we do and the prohibited transaction rule applies to us, then you've got to look at a model change. And if we go to an advisery model where there's going to be a fixed fee based on assets, it doesn't work. And the reason it doesn't work is number one, the asset sizes aren't enough if you're going to charge a small fee.
So if someone's putting $1,000 into an account in a year, that's $11.50 that's for fixed costs and paying the rep. In today's gas prices they probably can't drive across town to do that servicing. So you have that concern.
But the alternative to that is well, why don't you just make the advisery fee enough to cover all of your costs. Well, now you're at an advisery fee that is so exorbitant that it doesn't make sense for that account to open an IRA. So naturally what they would do is they'd look for other products. But we're believers in IRA, we think it's good for our clients. We think it's important to save money for retirement.
And, finally, you got to have a representative. The folks in our market, as well meaning as they are, they're not going to be solicited by other broker/dealers and they're very unlikely to walk into a bank and just open an IRA on their own.
That representative plays a crucial role. So in an advisery model there's all sorts of licensing requirements that they would have to go through to get themselves licensed as an investment adviser and other duties what would be continuing.
That's the struggle we have and that's the concern we have with the rule. What is very important to us is that the Department really understand how this rule affects the small investor, the starter IRAs, because the danger is if that's not understood, and it's just a bludgeon approach, that will substantially impact the ability of companies like ours and then a lot of companies like ours to service that initial small investor. And that's what we'd ask of the Department.
Mr. Davis: Okay. Thank you.
Mr. Tate: Hello. Good afternoon. And thank you for the opportunity to testify today. I'm Brian Tate with the Financial Services Roundtable.
The Roundtable supports strong consumer Protections for retain investors. We have long been supportive of the harmonization of the regulations for broker/dealers and investment advisers when providing personalized investment advice about securities to retail customers.
Consistent with Congress' interest in developing a uniform standard of care, we believe that these worthy goals can be achieved without subjecting broker/dealers and investment advisers to duplicative and overlapping regulatory regimes that create confusing -- confusion among investors and may not recognize and allow for differences in the business models, services and products provided by a range of financial services professionals.
Last year, Congress pursuant to Dodd/Frank, charged the SEC with studying the obligations of broker/dealers and investment advisers. The SEC was mandated to report on the effectiveness on existing federal, state, legal, or regulatory standards in the protection of retail customers relating to the standards of -- standards of care for broker/dealers, investment advisers and their respective associated persons when providing personalized investment advice and recommendations about securities to retail customers.
In their report, the SEC staff recommended that the SEC promulgate rules to implement a uniform fiduciary standard of conduct for broker/dealers and investment advisers when providing personalized investment advice about securities and to retail customers and such other customers as the SEC determines.
The staff recommended that the SEC define the standard of care as a duty to act in the best interest of the customer without regard to the financial or other interest of the broker/dealer or investment adviser providing the advice.
As part of the rulemaking, the staff recommends that the SEC address not only the clones on the universe -- uniform fiduciary standard, but that it also provide guidance on specific scenarios to assist broker/dealers in transitioning to the new standard.
Many of the issues that we would expect that -- the SEC address are included in the DOL's proposed definition of fiduciary. Accordingly, it is critical that DOL and the SEC work together to develop a practical approach that addresses investor protection needs but preserves investor choice and accommodates a range of business models.
The DOL's proposal would substantially increase the categories of service providers who are deemed fiduciaries for purposes of ERISA. The Roundtable believes that the wide reach of proposed language would have unintended consequences that could create uncertainty among service providers and potentially reduce the level and types of services available to benefit plan -- to plan beneficiaries and individual retirement accounts.
One fundamental issue that we need -- that will need to be resolved is the Department's prohibitions -- I mean, prohibits persons or entities that are deemed fiduciaries from engaging in certain activities. But the SEC generally allows entities deemed to be fiduciaries such as broker/dealers that are duly registered as investment advisers or affiliated broker/dealers and advisers to manage conflicts of interest by disclosing them to clients.
Under the proposed rule, an oral or written representation or acknowledgement by a person that is acting as a fiduciary or making recommendations would result in imposition of fiduciary status.
We agree that if a person providing advice represents or acknowledges that they are acting as a fiduciary, such a person should be deemed a fiduciary. The Roundtable is concerned, however, that if oral representations are sufficient to confer fiduciary status, faulty recollections by persons interacting with financial institutions could result in after-thefact fiduciary status. Thus, we strongly urge the Department to provide that a person can only be deemed a fiduciary by formal writing.
As proposed, there would be no longer -- as proposed there would no longer be a requirement that a plan fiduciary provide advice on a regular basis or mutual understanding. As a result, a person could be deemed a fiduciary as a result of one off conversation, an informal discussion with human resource professionals or other inadvertent triggers.
If a plan manager happens to have informal one off discussions at a conference with a variety of contacts, which the plan executes transaction and receives brokerage commissions, it is unclear whether each of these context in the context employers would then become fiduciaries. The risk of inadvertent fiduciary status will reduce the flow of information in the marketplace as broker/dealers and other financial institutions will sharply curtail the ability of personnel to have even informal communications with clients and potential clients.
Furthermore, without a mutual agreement requirement, misunderstandings between parties may arise. We believe that the current mutual agreement requirements provide certainty to both parties of a fiduciary relationship and creates an environment that encourages an exchange of information including any issues related to a conflict of interest.
Roundtable members are concerned -- next, the Roundtable members are concerned about the seller's exemption, specifically that regarding securities brokers, insurance agent or real estate brokers makes a recommendation to a plan regarding the purchase of a security or property and ends up not acting for the other side of the transaction. They will not be able to rely on this -- on this exception.
In addition, if this exception is adopted as proposed, we respectively ask that the Department clarify the meaning of "adverse interest." Also, we respectfully assert that a requirement to inform a party that otherwise has a customer relationship that is -- that a broker/dealer is adverse, could potentially result in investor confusion and effectively limit investor choice in selecting brokers.
Additionally, since the proposed regulation may expand the definition of investment advice to also include referrals to or recommendations of investment advisers the Roundtable believes that the seller's exception should be expanded to include recommendations regarding the purchase of services and not limit it to recommendations of purchases of -- or sales of property.
The Roundtable supports the Department's recognition that many service providers offer up platforms of investments that do not involve rendering investment advice but instead provide a menu of investments from which plan fiduciaries can select a more limited menu that will be made available to plan participants.
In the context of IRAs and 401(k) plans, however, we believe that it would be helpful for the DOL to provide additional guidance regarding what constitutes individualized needs. And we particularly ask that the SEC clarify the application of the investment platform exceptions to IRAs.
Roundtable members are keenly concerned that the elimination of mutual written agreement requirements and practical elimination of the seller's exception would greatly diminish, if not eliminate, the range of -- a range of account services including information tailored to a particular investor's needs provided to retail investors by broker/dealers. This would result in two classes of investors.
The first would be investors who can afford to pay higher fees based off the size of their accounts or assets under management. Those investors would receive investment advice.
The second class of investors would be those who have brokerage accounts and generally only pay fees when the, affected transactions receive investment advice that is incidental to their trades -- to those trades.
The Roundtable believes that if the regular basis and mutual understanding requirements are eliminated this second class of investors is likely to no longer receive investment advice unless the investor is willing to establish an advisery -- advisery account which likely will result in higher fees for the investor.
Next, further guidance is needed as to when the line between investment advice and investor education is drawn. We are concerned that the availability of information to non-advisery clients likely would also diminish because of concerns that educational information or opportunities to participate in occasional web casts or conference calls might be deemed investment advice and result in inadvertent fiduciary relationships.
Regarding appraisals, Roundtable members are particularly concerned that the exception in the proposed regulation has the potential of making every report provided by a trustee or custodian, a plan of fiduciary or fiduciary service.
We respectfully recommend that the Department revise the proposed text of the regulation by omitting the requirement that the report be provided for purposes of compliance with the reporting and disclosure requirements by the Act.
We are also concerned about the impact the inclusion of appraisals of securities and property could have on ESOPs as well as hard to evaluate assets such as swaps and derivatives.
We do not believe that the preparers of the appraisals, valuation or fairness opinions should themselves be deemed fiduciaries for purposes of the Act. Rather, we believe that the fiduciary responsibility should rest with the provider of investment advice to use appropriate diligence in selecting the preparer of the opinion or report.
We think it would be more appropriate to require this category of market participant to meet certain minimum qualification standards.
We also note that providers of fairness opinions are generally already subject to comprehensive regulation by the SEC as broker/dealers in the case of municipal securities and municipal advisers.
With respect to management of securities or other property the proposal applies to advice or recommendations as to the management of securities or other property; however, no guidance is provided as to the meaning of management of securities or other properties. For example, it is unclear whether this would include record keeping and other administrative services or even a recommendation as to a property management company to use for a rental property.
The Roundtable respectfully requests that DOL clarify that the phrase "management of securities or other property" does not include recommendations of administrative services, property management, or other non-investment management related services.
In regards to compensation, we believe that the proposed definition of compensation is too expansive and would include brokerage commissions, mutual fund sales and insurance sales commissions as well as fees and commissions based on multiple transactions involving different parties.
The proposal's inclusion of brokers' commissions including those with respect to mutual fund shares in the insurance products paid in the course of providing investment advice, steps ahead what Congress had directed to the SEC to consider whether to eliminate the broker exception from the definition of investment adviser under the Investment Adviser's Act.
The current statutory provision allows broker/dealers to provide investment advice in connection with the execution of securities transactions for customers as long as brokers --
(Bell rings signifying time is up.)
Mr. Tate: Can I get an additional minute?
Mr. Davis: Sure. Go ahead.
Mr. Tate: Thank you.
The current statutory provisions allow broker/dealers to provide investment advice as long -- in connection with the execution of securities transactions for customers as long as the broker receives only brokers' commissions for effecting a transaction and does not receive a separate fee for providing the advice.
The Department's proposal, however, would essentially make the ability of broker/dealers to avail themselves of this exception. Given that Congress specifically charged the SEC in the Dodd/Frank Act to study the regulation of broker/dealers and investment advisers to engage in rulemaking necessary to address any gaps in the regulation, we believe that the SEC and not the Department, should be charged with promulgating any regulation that potentially fundamentally changes the manner in which broker/dealers are compensated.
Finally, the Roundtable is particularly concerned that the application to affiliates is overly broad and far-reaching without identifying the actual potential harm to investors. It would be logistically difficult to track compliance for complex multinational financial institutions that engage in a variety of investment advice, transactional insurance, real estate and other potentially covered activities in numerous entities.
We respectfully ask that Department narrow its application to affiliates.
Thank you for your time and I'm happy to answer any questions you have.
Mr. Davis: Thanks so much, Mr. Tate.
We'll turn to the government panel now. Before we do, I just wanted to let people know we did have some substitutions over lunch.
Jeffrey Monhart is a senior member of our Office of Enforcement to my left.
To my immediate right is Ivan Strasfeld who is the head of our Office of Exemption Determinations.
Leslie Perlman with the Solicitor's Office.
Joe Piacentini and Fred Wong remain from this morning.
So with that, I'll turn to Jeff.
Mr. Monhart: Thanks, Michael.
I have a question for the witness from the Financial Services Institute. In your comment letter you make mention of the existing regulatory principles for brokers' suitability and best execution, but, of course, ERISA imposes different standards: prohibition against self-dealing and the duty of loyalty.
So in the space that you described, brokers dealing with small plans and participants, isn't it hard to ignore the potential for conflict when the broker is compensated solely by commissions?
Mr. Smith: The -- there really is a -- kind of fundamental tension here between regulatory constructs that are at work in this area. The securities law constructs, the insurance regulatory constructs, do not exclude the possibility that a representative can both look after the best interest of the client and be paid on a commission basis.
The ERISA regulatory construct has worked in a different way on that. The way you all have accommodated that, of course, is, you know, in the course of preparing this letter it was an occasion to kind of reflect back on all the work you all have done over the years to fit broker/dealers into ERISA's regulatory structure, you know, starting from five minutes after ERISA was enacted up through individual PTEs that you were granting last year.
The amount of time and effort you all have put into fitting broker/dealers into ERISA regulations is staggering it seems to me. I mean, there's been a significant part of the way you all expended your resources. And as best as we can figure out, it's worked. As best as we can figure out, the broker/dealers have continued to be able to provide by and large the services that the plans need on a viable basis for both and primarily acting in a non-fiduciary capacity. And we're not aware that there's been any, you know, systemic abuse that would suggest that the existing structure isn't working that you guys -- you all didn't succeed in what you set out to do, and that the existing structure is not effectively working for plans and their participants.
Mr. Monhart: One more.
Mr. Davis: Go ahead.
Mr. Monhart: And a question for the witness from the Roundtable, please. You coin an interesting phrase in your comment letter, "the inadvertent fiduciary status." And you mention that "the inadvertent fiduciary status might have a chilling effect on informal communications."
I'd just like for you to elaborate on that. It sounds like the inadvertent fiduciary status is sort of like kryptonite, it would have a chilling effect. But I'm not really following why that would be. In order for a plaintiff to make that a case you have to have a fiduciary, a breach and a breach that causes a loss.
So how would informal communications be chilled by this so-called inadvertent fiduciary status?
Mr. Tate: I would say that the overall goal for all of, I guess, the regulations from whatever department makes them, should be to encourage and facilitate conversations between all parties. And that -- that the appropriate disclosures are made, that the consumer or the investor gets all the information that they need to make good decisions. And I think that anything that we can do to help facilitate that process would be extremely helpful.
I think if there is a -- if there is still a gray area of who is and who is not a fiduciary and if I make a certain statement whether or not I am now a fiduciary when I'm only having a conversation or that we are just meeting for the first time or -- there is a number of scenarios that one could think of where one could say, as we addressed in our testimony, that are just conversations and aren't giving, I guess, regular advice on -- and it's not the primary basis for making a decision, and if those -- if those standards go away, then you're having a conversation and there is -- and coupled with the fact that there may or may not be any kind of written disclosure or written agreement that we are -- I am representing you at some point, I think it causes confusion.
And I think if you don't have those standards in place then, again, as we pointed out, after-the-fact that we've had a conversation, well, one person may be thinking that we're having a conversation for another reason and the other party thinks we're having a different kind of conversation I think there could be some confusion there at the end of the day. Once we step away from that conversation, a couple of days, weeks, months later and come back and say, hey, he was a fiduciary and the other party goes I don't believe we had that conversation. I thought we were talking about something else.
And so going back to our testimony, I think having a written mutual understanding, a written agreement that I am representing you in this X capacity, I think would be extremely helpful going back and saying overall for everyone's time, going -- you know, this is the conversation that took place and here's why and this is what we talked about.
Mr. Monhart: Thank you.
Mr. Davis: I don't have many questions.
I did want to make one observation though and I think it was, Mr. Smith, you talked about 35 years of work that the Agency has done in this space. At the same time, one of the premises of the regulation is the marketplace as it changed appreciably over the course of those 35 years and the kinds of conversations now that happen weren't conversations that happened 35 years ago.
One of the conversations we had yesterday with some members of the financial industry suggested that at least in this case, they did think there was some value to revisiting at least the regular basis and the primary basis requirements as promulgated in the '75 reg.
I think I heard from Mr. Tate, my understanding is I think that you guys are basically saying that you would not support revisiting even those two planks of the five-part test but for the rest of the panel would you be in agreement that those are two elements of the test that should be revisited given the way the market operates today?
Mr. Smith: I'm not clear that I agree with that point. Plainly the market, the -- you know, well marked transition from a defined benefit universe to a defined contribution universe, plainly there have been changes in retirement plans in that respect.
It's not clear to me though that the nature of the conversations or the need -- the -- kind of the fundamental sorts of services that plans need from financial service providers is materially different just -- because of that transformation.
We continue to think, for the reasons we've discussed, we continue to think that it's essential that there be an avenue for broker/dealers acting in the ordinary course to continue to provide services to -- on a non-fiduciary basis to plans. We think that the consequences of going beyond that are potentially - - are very significant in terms of what it would mean for products and services necessary to plans that would be available to them in the marketplace.
So our concern is primarily that there needs to be a reliable and certain avenue to get to that result. It does seem to us that there are -- there are -- there's more than one way to get there. If you all judge that you need a revision in the test for other purposes but you can find a way to give us a certain reliable way to structure appropriate arrangements other than a fiduciary basis, you know, it's the -- kind of the certainty and the reliability of fairness opinions, that outcome, I think is what's most important to our members.
Mr. Davis: Okay. And just -- one question for the members from Primerica. It sounds like you guys provide a tremendous service in knocking on the doors that you knock on and talking to new entrants, new savers.
I did want to understand a little bit better though in terms of -- you talked about the commission structure, the -- so the brokers earn a commission for opening the account. Is there also a commission earned for the sale of certain products? And if that is the case, are those arrangements disclosed in the conversations? And if so, how are those compensation arrangements disclosed?
Mr. Schneider: So I'll start it and I'll let Mr. Watts jump in. They do earn a commission. They do earn a commission for the sale of the products. All of our compensation is disclosed.
We also -- and this is where the prohibited transactions issue comes in for us.
Mr. Davis: I'm sorry, when you say it's disclosed, what form of disclosure happens? Is it within a contract, is there a conversation, typically, how does that happen?
Mr. Watts: Well, it's disclosed in the -- in the product prospectus initially. And we also supplement that with our own disclosure documents that we deliver to the point of sale.
Mr. Davis: Okay. Keep going.
Mr. Schneider: And so, the -- the struggle, I think, that firms like ours are going to have is we also, for example, will receive a record keeping fee. We keep the records. We have to have that infrastructure. The mutual fund company doesn't want to -- really want to do that for these small accounts.
And so we will receive a record keeping fee, a set amount to -- from the fund company to help us defray the expense, the fixed expense of maintaining that account.
We -- again, we make disclosures about that that's in our materials so we address it with the client. But if that is taken away, and only the client is the only source of those funds, it really becomes cost prohibitive for the client to have an account. That's what's going to -- that's what's going to happen.
And, because if -- let's say, you're putting away $50 a month into a mutual fund and at the end of the year it's $600 if I've done my math right. You know, $600 you're going to have at the end of that year. Not bad, frankly, if you're a nurse or a laborer or a plumber, you've gotten started. But if you have to absorb all of the costs associated with the maintaining that account yourself, and upfront, our modeling shows that we would have to take hundreds of dollars from that client in order to make that work today. And that doesn't make any sense for the client.
Right now the fund company will help defray that expense. Again, we deal with it, we deal with the disclosure, someone's got to be that record keeper. So someone's going to be paid for that. It could be a third party and then you avoid any of the -- of what I think you'd be concerned about, which is, you know, a payment coming to us. So the payment would go to someone else. But the trouble is when the payment goes to someone else and we deal with the client, because it's our call center and all that, we don't have any source of revenue to defray that expense other than that client. And that's the problem.
So there's got to be some flexibility on that aspect of the rule for accounts of a size like ours.
John, do you want to add anything to that?
Mr. Watts: No, no.
Mr. Schneider: Okay.
Mr. Davis: Last question.
Mr. Tate, you've already sort of dealt with your concerns or the Roundtable's concerns about the seller's exception. Just curious from other members of the panel, there was a seller's exception in the reg as codified and put forward, but I assume that you think that the exception as it's currently drafted is too restrictive.
And, first, is that the premise of what you're saying? And two, what enhancements would you make to the exception beyond what was promulgated?
Mr. Smith: I'll be glad to speak to that.
Mr. Davis: Okay.
Mr. Smith: The -- in our judgment, the exception as drafted seems to speak clearly to counterparties and is less clear to us than it speaks to intermediaries.
It speaks in terms of -- of property it less -- it less -- it clearly speaks to sales activity with respect to the management of plan assets.
It speaks -- it requires a statement of adversity of interest that's -- it's not clear to me why we'd want to be encouraging anyone to be thinking in those terms. It seems to us that could be much more effectively formulated as -- as not being in a position to act as a risk fiduciary, go to the ultimate conclusion.
So it seems to us that it is -- it is -- to the extent that it, as drafted, it only applies to counter-parties, it is too narrow. And to the extent that it -- and it seems to use that you could improve and refine the way you formulated a seller. If your objective is to provide an exception in circumstances where a service provider is well and truly acting in a selling capacity as distinguished from a fiduciary capacity. It seems to us that you can -- you can improve the way that the exception has been drafted.
Mr. Tate: I would like to add -- I agree totally with what Mr. Smith just mentioned, but also stating from -- if you're having a long-term relationship, if you're Primerica or any other company that's going to someone's house or meeting someone in a professional environment, you don't want to start your relationship off as stating we have opposed interest in this.
I mean, I don't know if you go to the store, the store has, you know, an opposed interest, they want to make money and you want to buy a product. If they stated off -- you know, from the jump, that our interests are opposed to each other, you're going to sit there and pause and go why is he telling me this before we go further into our relationship.
Mr. Davis: And we took earlier testimony on this point too, that there were some concerns expressed about the use of the term "adverse." And I would make the same request of you that if you have language that you think sort of captures the concept in a way without the use of that term, the record's going to be open another 15 days after the hearing, we'd welcome your input on that.
Mr. Tate: Thank you. We'll definitely look into it.
Mr. Davis: Thanks.
Mr. Strasfeld: My turn?
Mr. Davis: Yes.
Mr. Strasfeld: Mr. Smith?
Mr. Smith: Sir.
Mr. Strasfeld: Can you hear me? Can you hear me now?
You seem to be our every go-to guy.
I had a couple of questions. So your -- your small brokerage business is it -- what are the products that they sell? Is it just stock, bonds, insurance?
Mr. Smith: No, they typically -- they most typically sell mutual funds and variable insurance products.
Mr. Strasfeld: Right.
Mr. Smith: Sometimes fixed insurance products. They may offer a variety of services, sort of pertinent to that.
Mr. Strasfeld: Right. So they're dual registered as broker/dealers?
Mr. Smith: They are very often dual registered, yes.
Mr. Strasfeld: All right. And so in almost all those instances they receive commission income for the --
Mr. Smith: When they're acting in their broker/dealers capacity, that's correct.
Mr. Strasfeld: And what about as an insurance agent?
Mr. Smith: Typically, in a commission basis as well.
Mr. Strasfeld: All right. So at the -- so all of that under -- like every -- well, everything under ERISA is illegal. You start off with that premise. So to the extent -- so the next hurdle would be well, since it's illegal there are a bunch of statutory exemptions. So I assume currently you're relying on the statutory exemption for service providers since, you know, you're of the view you're not a fiduciary but for this proposal?
Mr. Smith: That or 75-1 or some other --
Mr. Strasfeld: All right.
Mr. Smith: -- some other exemption that doesn't -- that is not premised on fiduciary status.
Mr. Strasfeld: So to the extent that you -- you do become a fiduciary, and I guess it's one of the reasons I'm up here, trying to gauge you know, what exempt -- what class exemptions or individual exemptions are available or what exemptions might have to be considered by us to the extent this goes forward.
And so currently there are two exemptions for fiduciaries which seem very relevant to you which is 86-128 for broker/dealer, you know, for a --
Mr. Smith: Exactly.
Mr. Strasfeld: -- broker/dealer fiduciary and 84-24 where the insurance agent becomes an investment adviser.
Does that -- and those are -- you know, those are -- at least in my view, which is, of course, I've been doing this for a long time, do not seem particularly onerous. They're basically, upfront approval, disclosure and -- for instance, in the broker/dealer universe there's be an annual portfolio of turnover ratio which I always found to be relevant, at least in my personal finance.
Mr. Smith: Yeah, I would agree other than the -- the additional reporting that are 86-128 is somewhat -- is atypical for the way broker/dealers typically do business and does entail some additional costs. But I substantially agree.
Mr. Strasfeld: So if -- besides those two class exemptions what would -- what would be missing?
Mr. Smith: Well, I mean, to the extent that we are engaged in Agency transactions other than in mutual funds, you -- you are moving from 408(b)(2) or 75-1 to 86-128.
Mr. Strasfeld: Right.
Mr. Smith: Principal transactions. That's not a large part of our business but it is an occasional part of our business. Principal transactions if we're not a fiduciary we can rely on 75-1, if we are a fiduciary, we're out of business.
Mr. Strasfeld: Right. Now, what kind of principal transactions are they? Is this equity or debt primarily?
Mr. Smith: I don't know the answer to that.
Mr. Strasfeld: All right. Just one last observation. You said -- I believe you suggested that you would -- you would like it if you could -- if the service provider could disclose to the plan that he's not a fiduciary.
Mr. Smith: Yes.
Mr. Strasfeld: Now, that works under securities laws but it does not work under ERISA since ours is a functional definition. So you could say you're not but if you are, you are. And there's probably not much we could do about that. That's --
Mr. Smith: Well, I'm not sure I agree with you on that. The -- we have an existing definition under the existing rule. Certainly, it's black letter law that we have a functional definition.
Mr. Strasfeld: Right.
Mr. Smith: But the expectations and understandings and the services that are provided by the parties under the existing definition informs the - - helps to inform the outcome on this, correct?
Mr. Strasfeld: But you're really talking -- you're limiting yourself to the construct of an investment advice fiduciary, you're not talking about the other functional --
Mr. Smith: No.
Mr. Strasfeld: Right. So that's -- all right. That's fine.
Mr. Smith: That's right. Exactly right.
Mr. Strasfeld: All right. I got you.
Mr. Smith: You know, and our suggestion on this point is that there's a value to certainty on this issue, a value for plans and participants, the certainty on the investment advice fiduciary issue.
Mr. Strasfeld: Right. But in that context only?
Mr. Smith: Specifically in that context, correct.
Mr. Strasfeld: Primerica, I still don't actually understand what you do once you get in someone's house?
Mr. Schneider: Well --
Mr. Strasfeld: What is it you're selling them? You know, obviously I've been looking at products for 30 years so I'm -- from my vantage point, what kind of products are you selling them, you know, and how -- you're obviously compensated by and large through commissions of some sort. Well, what is it you're actually selling them?
Mr. Schneider: Well, I'll go -- first of all, we have many reps who are willing to come to your home and help you understand this.
But what -- what we're selling, is --
Mr. Strasfeld: My father was a broker and I barred him from my house.
Mr. Schneider: Well, what we're selling, first of all, we sell term life insurance. So Primerica owns a life insurance company.
Mr. Strasfeld: Right.
Mr. Schneider: We are opening an IRA for the client and so in that IRA we exclusively sell mutual funds. We do not sell equities, we do not do options. We're sort of more defined by what we don't do. So we will sell mutual funds.
Of course, we also will do non-IRAs so, you know, non-qualified funds --
Mr. Strasfeld: Right. Now, the mutual funds --
Mr. Schneider: -- you can open with us.
Mr. Strasfeld: -- they can't be no-load cause there's be no way you could get compensated.
Mr. Schneider: Correct.
Mr. Strasfeld: So what kind of mutual -- they are -- they're just load funds?
Mr. Schneider: Yeah, so you -- American funds, Fidelity, Van Kampen, Legg Mason, AIM, Pioneer, all the major funds. And the problem that we have and going back a little I think in a way to Mr. Davis' question, the variable -- the variable nature of the compensation is an issue under the Department of Labor rules. So we actually levelize compensation at the rep level.
So from a representative's standpoint, the representative is indifferent to what's sold. They're going to get the same comp no matter what the client buys.
Mr. Strasfeld: How does that work, because that's actually pretty interesting? Because most brokers -- just like my dad, most broker/dealers, you know, if you don't generate commissions by the end of the month, you don't eat. And you -- you know, you can only eat what you kill.
So how -- your model seems different. How does -- how does it work?
Mr. Schneider: Well, our model is different because we will allow representatives to be part-time. So we don't have any quotas. So they'll still eat if they don't sell.
Mr. Strasfeld: Right.
Mr. Schneider: So, but they're -- but in order to reach this market, this demographic, what we've got to do is put a -- get a part-time representative. Think a teacher.
Mr. Strasfeld: Right.
Mr. Schneider: Nine months out of the year in teaching, during the summer they can be a Primerica representative earning income.
Mr. Strasfeld: But how exactly are they compensated if they're not getting commission income?
Mr. Schneider: They are getting commission income.
Mr. Strasfeld: But how is it leveled out?
Mr. Watts: Well, it's not -- it's not leveled from -- the firm is getting variable payments from the mutual funds.
Mr. Strasfeld: No. That I understand. But how is it translating --
Mr. Watts: We have leveled within the firm by establishing what we call commissionable dealer reallowance. We have capped it where the cap -- we've capped it at a percentage so that everybody gets paid the same no matter what fund they sell.
Mr. Strasfeld: So, for instance, if -- they would get 30 basis points if they sold the American funds or Van Kampen or whatever. Whatever fund they sold, their piece of the action would always be the same across-the-board?
Mr. Watts: Yeah, if they sold an equity fund that had a 5 percent load and they -- and somebody else sold an equity load that had a 5-1/2 percent load, both reps are only going to get paid on the 5 percent.
Mr. Strasfeld: Right. But they would get different amounts for selling a bond fund or an equity fund?
Mr. Watts: Correct.
Mr. Strasfeld: Although it would be the same for all bond funds and all equity funds?
Mr. Watts: Correct.
Mr. Strasfeld: All right. And, again, the same question as I asked earlier, you're -- I assume you're relying on our service provider statutory exemption based on the assumption that to date you're not a fiduciary?
Mr. Schneider: Right. We don't -- we do not consider ourselves a fiduciary.
Mr. Strasfeld: Right. So you comply with our service provider statutory exemption, which is available for non-fiduciaries? Cause you are -- I mean, you acknowledge you're providing a service to a plan or in this case an IRA? It's not a trick question.
Mr. Schneider: No, I know. We're not a -- we're not ERISA lawyers. We're not ERISA lawyers. We do have an ERISA lawyer in the audience.
Mr. Strasfeld: Let me go -- that's even better.
Let me rephrase it because that could be somewhat confusing. You're -- you're -- as far as IRAs go, they're -- the transactions are still prohibited but they're looked at in terms of the Internal Revenue Code. They have their -- their parallel-prohibited transaction provisions and they have parallel statutory exemptions.
So for our Title I plan there's a statutory exemption for providing services to the plan and there's a parallel provision under the Code. So in the absence of your compliance with that regardless of whether you are a fiduciary or not, you would be engaging in prohibited transactions.
So I'm asking and assuming that you're complying with the same statutory exemption under the Internal Revenue Code for the provision of services to IRAs.
Mr. Watts: We believe so.
Mr. Strasfeld: I'll answer it.
Mr. Schneider: Yeah, I mean --
Mr. Strasfeld: The answer has to be "yes," to --
Mr. Schneider: Yeah, I'm sure the answer the answer is "yes." We're not going to -- we're not going to -- in that respect, we're not going to be any different than tons of broker/dealers.
Mr. Strasfeld: Right. So that's --
Mr. Schneider: We're going to look just like them.
Mr. Strasfeld: Because it was just -- like, my point earlier, if you're not a fiduciary you still have prohibited transactions and you need to use a statutory exemption. If you do have -- if you are a fiduciary, then chances are, as I noted, you'll have to turn to a class exemption. And you would have to -- obviously, you -- you know, to the extent you do become a fiduciary under our reg as ultimately proposed, you will be forced into using class exemptions as well or - -
Mr. Watts: You do have the option of --
Mr. Schneider: And I understand -- my understanding is -- again, without being an ERISA lawyer, my understanding is those exemptions will be problematic that -- for example, one I heard if you're an insurance agent and also an investment adviser.
Our representatives have series 6 mutual fund licenses, they're not investment advisers. It becomes a problem to make them an investment adviser.
Mr. Strasfeld: Well, no, no, no. You don't -- under -- our term "investment adviser is different.
So the question is: If you come -- if you -- for instance, if you came in under our old or actually, it's our current investment adviser, you would be a fiduciary by reason of providing investment advice but it would require no special designation under insurance or securities law. You would just functionally be a fiduciary and you would need to comply with that exemption.
And that exemption is basically kind of disclosure generated with approval and there's disclosure of commissions and fees and stuff and mutual funds and insurance.
So it seems to me there really should be no reason you couldn't comply with that. It doesn't require a special designation of fiduciary. You are -- if you're functionally an investment adviser you're forced into that exemption.
Mr. Schneider: I'll take that as good news, but that's not -- our understanding is it's problematic. Perhaps we can address it with, you know, a supplemental comment.
Mr. Davis: That's what I was going to suggest.
Mr. Schneider: That precise point.
Mr. Davis: If you want to go back and talk to your ERISA staff that --
Mr. Strasfeld: Yeah, as to why it doesn't fit. And I guess, Mr. Smith --
Mr. Smith: Yeah.
Mr. Strasfeld: -- can do the same.
Mr. Smith: Yeah, Ivan, and the other point, of course, is I mean, the choice is either to observe the exemptions or leave the market.
Mr. Strasfeld: That's right.
Mr. Smith: And I was talking to a -- last month to a -- a broker/dealer of substance, it's a regional firm, operates in multiple states, is -- doesn't have Primerica's 20,000 representatives, but probably is somewhere between 500 and 1,000 representatives. They probably have a gross revenue of about 75 million a year.
Their conclusion is they can't afford the risk. This is -- it's a privately held firm, they have about $3 million of net capital under FINRA requirements. They just can't -- they just can't see - - even if we can give them prohibited transaction solutions, they just can't see taking on the risk of becoming a fiduciary and they're doing good things for people in IRAs and the micro and small plan market.
Mr. Strasfeld: I'm questioned out.
Mr. Davis: Okay. Thanks.
Ms. Perlman: I really only have one short question and I apologize if this has been asked before. But everybody's talking about the cost of compliance, but have any of you actually quantified what it would cost?
Mr. Schneider: We have not.
Mr. Watts: We have not.
Mr. Schneider: Well, we've quantified what we would have to do to go to an advisery model. And what we've looked at is we would have to have a minimum account size of $25,000 for that to work. So, and, you know, we're still doing -- which is basically not serving our market, because to get to that level that's very difficult for any middle market person to get to that level. So we've looked at that.
In terms of the compliance and cost, I mean, obviously you're going to have increased cost, but I think from our standpoint that's not the issue. It goes back to can we afford, can we structure the compensation from the client in a way that allows the client to get the service from a representative? Can you do that?
We don't think we can do that under the rule as the Department of Labor has proposed it. That's why we're very anxious to have the dialogue with the Department to see what can be done. Because I have to believe it's not your intent to force out of the market firms that are opening standard IRAs for, you know, kind of regular folks. I'm sure that's not what you're interested in doing.
And so there's got to be a -- I would think there's got to be a solution to that. I would hope.
Mr. Piacentini: So, my question is also for Mr. Schneider. And I'm the economist on the panel so I'm going to ask about the economics, I think, of what we've been talking about for more of the legal dimensions of it.
And in a way I think your explanation of the compensation arrangements and so forth in your market segment have really helped me get my head around a theme that's been going on this morning which is that some business models compensation arrangements work where others don't.
But I still don't quite have it, so I'm hoping you can help me just a little bit more. So you couldn't service small accounts if you had to use a flat fee model or an asset-based model. And you said if you tried to it would be exorbitant. And, yet, clearly you are generating the revenue you need to cover your costs now. The business model does work.
So whatever that exorbitant revenue -- whatever revenue would be exorbitant in one sense is not in another sense, the same revenue I guess, cause you have to generate the same amount of revenue.
Mr. Schneider: There's really two reasons. And let me try and -- our time -- I guess we still have time.
First of all, part of it is legal. So under -- as I understand -- again, we're not ERISA, but as I understand it under the Prohibited Transactions Rule, you can only get compensation from the client. You can't -- it would be a violation of your fiduciary standard to take compensation from the fund or at least unequal compensation, revenue sharing, for example.
Mr. Piacentini: This is revenue sharing we're talking about?
Mr. Watts: Record keeping.
Mr. Schneider: Record-keeping fees. So if you cut all that out, then the client needs to pay that. So that client -- and the client needs to pay that upfront.
Mr. Watts: Or annually.
Mr. Schneider: Or annually. And it needs -- and they're a small account when they start.
Mr. Piacentini: Right.
Mr. Schneider: And the account is so small it can't absorb those expenses.
Mr. Piacentini: But if that piece of the revenue is being filled in now by revenue sharing back from the fund, then it sounds like that is in some sense being allocated to the larger accounts, right? And that that's cross subsidizing to help you open small, open new accounts and incubate small accounts?
Mr. Schneider: So that's the other reason I was going to get to.
Mr. Piacentini: That's kind of what's going on. So if you charged a -- an asset-based fee that was similar to the revenue sharing, then that would perform the same function?
Mr. Schneider: You would have to be a 30 percent fee.
Mr. Watts: But nobody would open the account.
Mr. Schneider: Yeah.
Mr. Piacentini: No, no. I'm saying -- I'm saying if you had in the same proportion as revenue sharing is now -- and, again, it would fall disproportionably out of larger accounts, but wouldn't that end up being essentially the same money coming from the same place?
I mean, if it's revenue sharing now it's built into the expense structure of the mutual funds, it's reducing the net return, right? I mean, that's how that works?
Mr. Schneider: But the structure today helps accounts, smaller accounts before they're bigger accounts because the mutual fund company is going to pay us a record keeping fee, let's say $18 and they're going to pay Merrill Lynch a record keeping fee of say $18. Merrill Lynch has $200 billion of assets under management. We have $20 billion of assets under management.
And so in a way, we're aided by that structure. That helps companies open small accounts. And so we're the beneficiary from an economic standpoint of that.
Think of it like a -- I hate to use the analogy, but going through a buffet line. Everyone pays the same price. Some people really load up their plate and the small investor is a very -- that's a costly account to have. The guys who load -- so we're the load-up-the-plate guys.
Then some go through a buffet line and they'll just take a little bit. They help defray the expense of the small investor. And so because it's sort of a -- more of fixed fee that you'd get. And that works for everybody. Once you take that away and you need to fully allocate the expense on just that IRA, just that investor, that expense becomes prohibited.
What the -- what the revenue sharing and other payments do for us is it basically helps us to pay for our platform, our fixed costs, that's what that helps. And once that's taken away and the full load goes on the investor, it's too big a load.
Mr. Watts: And the expenses of that account are actually allocated to that investor. It is prohibited for that investor to open the account.
Mr. Schneider: Yeah, it just does it for --
Mr. Piacentini: Right.
Mr. Schneider: And it's got to be upfront. So the other thing is -- in a way it's financed over time otherwise.
Mr. Piacentini: Thank you.
Mr. Schneider: I mean, the economics are interesting and it may be worth addressing in more detail. I suppose we're out of time.
Mr. Davis: Yeah, but again, you can supplement the record if you'd like to.
Mr. Piacentini: Thanks.
Mr. Watts: If you have questions for us that we haven't answered, then we will.
Mr. Piacentini: All right.
Mr. Watts: If you want to get them to us, we'll to our best to answer them.
Mr. Piacentini: Yeah, great. Thank you.
Mr. Davis: Thank you.
We'll call Panel 12 to the stage. Jennifer Eller, Real Estate Appraisal Coalition. Charles Tharp, Center on Executive Compensation and Vincent Vernuccio, Competitive Enterprise Institute.
Let's go ahead and get started. We'll start with Ms. Eller.
Ms. Eller: Thank you. Good afternoon. My name is Jenny Eller and I'm a principal at Groom Law Group.
I'm testifying today on behalf of the Real Estate Appraisal Coalition, a group of firms that value and appraise real estate assets. On an annual basis, this coalition is responsible for providing valuation services with respect to over half a trillion dollars in real estate assets belonging to ERISA plans.
We appreciate the opportunity to comment on this important proposed rule.
At the end of the day the debate over the proposed rule is a discussion about whether and how broadening the definition of fiduciary will better protect pension plans. It's the view of Coalition members that as it relates to appraisal and valuation of real estate held by plans, the proposed rule would not provide enough additional protections to plans to justify the additional cost.
Under the proposed regulation, a person providing advice on an appraisal or a fairness opinion about the value of real estate held by a plan may be deemed a fiduciary.
In the Preamble to the proposed rule, the Department specifically notes that including real estate appraisal activities within the definition of fiduciary activities would be a change from current law. I can think of two reasons why the Department might consider broadening the definition of fiduciary to include real estate appraisal activities.
The first would be to impose a set of conduct standards on real estate appraisers. And the second would be to prohibit fee conflicts.
In the Coalition's view, this reasoning would be justified if there were no existing standards of conduct for real estate appraisers or if existing standards were inadequate or non-uniform, and if there were evidence of misconduct or fee conflicts on the part of appraisers. However, just the opposite is true.
First, there is an existing comprehensive uniform set of appraisal standards known as the Uniform Standards of Professional Appraisal Practice or USPAP that applies to all real estate appraisal activities. These standards govern all aspects of the appraisal process, including substantive knowledge and experience required of each appraiser, the performance of appraisals, appraisal reviews, appraisal report content, including client disclosures and appraisers' ethical obligations.
The ethical obligations in the standards are thoroughly defined and specifically prohibit the performance of an appraisal with bias or an intent to mislead or defraud. The standards also prohibit appraisers from receiving compensation contingent upon the reporting of a predetermined result or upon the amount of a value opinion.
The Department has now identified appraiser misconduct or fee conflicts in the context of real estate appraisals undertaken for employee benefit plans as an area of focus let alone an enforcement priority. The Department's been very clear about its enforcement priorities in recent years and has stated that it is focusing enforcement resources on areas where the Department perceives the greatest threats to participants' retirement security. However, the Department has no enforcement initiatives involving real estate appraisal activities.
As recently as 2008, in testimony to the ERISA Advisery Council on hard to value assets, the Department did not identify real estate appraisal and valuation as a concern. The Department's lack of findings identifying problems in this area demonstrates that additional regulation is unnecessary and will add little value for plans.
Now, I'd like to talk a little bit more about the USPAP standards because we think it's important that you understand the degree to which federal government regulators oversee the establishment and enforcement of these standards and the extent to which the standards are already incorporated into federal law.
The Federal Financial Institutions Examination Council or FFIEC is the inter-agency body of federal financial regulatory agencies and includes the Board of Governors of the Federal Reserve, the FDIC, the National Credit Union Administration, the OCC, OTS, the newly created Bureau of Consumer Financial Protection and the Federal Housing Finance Agency.
The FFIEC includes the Appraisal Sub- Committee which oversees state appraiser regulatory programs, monitors appraisal standards of federal financial institutions, maintains a registry of state certified and licensed appraiser and monitors and reviews the operations of the Appraisals Standards Board, the entity responsible for issuing the USPAP standards.
The original goal of establishing federal agency oversight of appraisal standards in 1989 was to ensure that appraisers acted under uniform standards.
In 2010, as part of the Dodd-Frank Act, Congress updated and strengthened FFIEC oversight of appraisal standards in response to the financial crises.
Federal agency oversight of appraisal standards also means that the standards are incorporated into federal regulations. For example, regulations issued in December 2010 by all of the FFIEC agencies require any federally regulated financial institution to have standards in place for monitoring real estate appraisers. The regulations specifically incorporate the USPAP standards.
As a result, federal, and as a practical matter, state regulated financial institutions rely on USPAP standards to select, evaluate and monitor real estate appraisers, including when these institutions are acting on behalf of employee benefit plans. The USPAP standards require impartiality, objectivity and independence. Appraisers are not permitted to advocate the cause or interest of any party.
A significant concern for appraisers is whether and how this focus on objectivity can be reconciled with the fiduciary duty under ERISA section 404 to act solely in the interest of participants and beneficiaries.
The requirement that appraisers act with strict objectivity is also at odds with the assumption in ERISA section 406(b)(2) that a fiduciary is always acting on behalf of a plan.
Appraisers are also concerned about ERISA's co-fiduciary liability provisions and the extent to which this new source of liability will mean that appraisers are required to monitor the actions of a fiduciary to whom the appraiser provides services.
The limitation in the proposed regulation that specifically addresses appraisal activities is also problematic. First, the limitation puts the burden on the appraiser to demonstrate the understanding of the recipient of appraisal information about the appraiser's role. This is difficult in any case but it's particularly difficult where as the proposed rule appears to envision, the appraiser is working for a party with "adverse interests" to the plan. And the limitation would require that the appraiser communicate the fact that it is not an undertaking to be impartial.
It would be difficult, if not impossible, for an appraiser to comply with USPAP and to comply with this limitation.
Fiduciary status and the accompanying expansion of the scope of appraisal firm liability would necessarily result in increased costs to plans. Most real estate appraisal firms are simply not organized they cannot conduct business as an ERISA fiduciary. To undertake this responsibility would require firms to incur additional expenses associated with insurance and legal compliance among other things.
Given the ubiquity of the USPAP standards and the fact that these standards are intended to promote uniformity in appraiser regulation, we submit that layering ERISA fiduciary responsibility on top of USPAP would be costly, disruptive and burdensome without adding meaningful value or protection for plans.
ERISA imposes fiduciary duties with respect to valuation of plan assets including real estate investments upon a plan's administrator. Specifically, the administrator of an ERISA plan is required to report current value of the plan's assets on the Form 5500.
The Department has advised plan fiduciaries of their duty to understand and evaluate valuation information received about plan investments. If the Department is concerned about valuation issues, it should provide guidance to plan administrators and investment fiduciaries on their duties in connection with the valuation process.
Valuation guidance would be consistent with the recommendations made by the 2008 ERISA Advisery Council Working Group on hard to value assets and by the U.S. GAO in a 2008 report on Pension Plan Investment and Hard to Value Assets.
The Coalition does not believe that a real estate appraiser undertaking traditional appraisal activities should be entered as a fiduciary. To the extent that the final regulation could impose fiduciary status on appraisers we recommend that the Department include a specific limitation such that real estate appraisers who conduct an appraisal subject to the Uniform Standards will not be treated as providing investment advice under ERISA.
Incorporating these standards would leverage off of existing uniform standards to ensure that employee benefit plans and participants are protected.
We appreciate the opportunity to testify on this proposal and we look forward to working with the Department to craft a workable solution.
Mr. Davis: Thank you.
Mr. Tharp: Good afternoon. My name is Charlie Tharp and I'm the Executive Vice President for Policy at the Center on Executive Compensation here in Washington.
The Center is a research and advocacy organization that seeks to provide a principles-based approach to executive compensation.
In my testimony today I'll hit on three key points. The first point is that we believe that the proposed regulations are overly broad and would have an unintended consequence of imposing costs and perhaps limiting access to valuable information and services to plans.
Secondly, we advocate that if someone is considered a proxy adviser is considered a fiduciary today under the rules, that that shouldn't change.
And the third recommendation we have is that we'd like to have the Department of Labor undertake a comprehensive study of the proxy advisery industry, and I'll give you some details as to why we think that is important.
The Preamble of the proposed regulations notes that the definition of a fiduciary would include, for instance, advice and recommendations as to the existence of rights that are pertinent to shares of stock and that would cover voting proxies.
First, with respect to the regulation itself as I've indicated, we believe that the proposed definition of fiduciary is too broad and would not -- should not be adopted as it's currently drafted. The fear, again, is as been mentioned by others, is that there would be individuals who currently are considered to be fiduciary advisers, would be swept under that and would increase the cost to plan participants and to sponsors of plans. Merely providing information without more we don't believe should be deemed to be a fiduciary adviser.
It may be helpful for a second just to provide some background of the proxy advisery industry because that's where the bulk of our comments are focused. Because the voting of proxies is an important fiduciary duty and the annual volume of proxy information has increased tremendously, institutional investors rely on proxy advisers for advice.
The proxy advisery industry has undergone significant consolidation at the same time their influence has increased due to the following factors:
First, the share ownership on the part of institutional investors has increased from 47 percent of the fortune 1000 in 1987, to over 76 percent today. The expansion by the SEC of permissible proposals that may be included in shareholder resolutions has also increased. In the growth and the volume of information that must be analyzed has caused companies to rely high heavily on proxy advisery firms who must analyze hundreds of thousands of pages of information just on compensation alone.
The influence of the proxy advisery firms on the exercise of voting rights is projected to increase as regulatory changes, such as we've just witnessed under Dodd-Frank, further increase the number of votes that must be cast and hence, the influence of the proxy voting process.
Proxy advisery firms today are scarcely regulated through a patchwork of regulations that do not clearly cover the activities of the proxy advisery industry. The patchwork, in fact, was part of the motivation for the SEC's 2010 concept release, which requested input on proxy advisery industry. The release notes that some have argued the proxy advisery firms are controlling or significantly influencing shareholder voting without appropriate oversight. There are many conflicts in the proxy advisery industry but the most serious problem facing the industry is a conflict of interest. As noted in the 2007 GAO report the largest and most influential proxy advisery firm, ISS, provides services to companies to help them gain favorable votes on their resolutions and proposals while at the same time, selling the services of recommendations on those very votes to their clients.
Proxy advisers also have a conflict of interest when they provide voting recommendations on shareholder initiatives that are backed by their owners or institutional investors who are offering their clients such as pension funds. This economic relationship does give the impression of a favorable analysis of those proponents' resolutions.
In particular, Glass Lewis, which is the second largest of the proxy advisery firms, is owned by the Ontario Teacher Pension Plan Board, which is one of the largest activist institutional shareholders. There's an increasing parallel interest between the conflicts that were noted in credit rating agencies and those of the proxy advisery firms. Just as the credit agencies would receive fees for rating a company this is similar to the proxy advisery firm selling their fees and then recommending votes on those same companies.
Proxy advisery firms are not accountable for the inaccuracies in their analysis and we did a survey just in 2010 of the 300 companies and the Human Resource Policy Association and our subscribers in the Center, and we found that 53 percent of the respondents had experienced inaccuracies in the final published report on their compensation programs.
Perhaps due to industry pressures we're seeing more of these inaccuracies. To increase profitability, the proxy advisery firms have outsourced the proxy data mining and research activities to low cost countries such as the Philippines and have hired seasonal temporary employees with little or no business or proxy experience. We believe that solutions to this inaccuracy problem would include the enhancement of the quality control procedures, including giving companies a chance and sufficient time to comment on the reports so they can help identify and correct inaccuracies currently, at best you give 24 hours off and over a weekend, establishing protocols for dealing with inaccurate reports.
There's also another concern and it is in part due to the economics of the proxy advisery industry that they use a one-size-fits-all approach to governance voting. We believe that they should take into account differences in company situations, strategies and approaches and have a tailored informed recommendation on voting proposals.
The ERISA requirements enforced by the Department of Labor and the investment advisery requirements enforced by the SEC fail to provide a comprehensive regulatory structure for the proxy advisery firms.
Starting with the Avon letter in 1988 the Department of Labor has held that the voting of proxies is an important fiduciary activity and a valuable plan asset under ERISA. Therefore, the fiduciary duties of loyalty and prudence apply to voting. Moreover, pension fund fiduciaries including those that delegate proxy-voting responsibilities to their investment managers have a responsibility to monitor and keep accurate records of their proxy voting activities.
To the extent that proxy advisery firms do exercise discretion over the voting of proxies, they are considered fiduciaries under existing regulation and the term of fiduciary. However, only one of the firms ISS actually votes proxies and would fall under that fiduciary responsibility, not Glass Lewis.
While the Department of Labor seeks to preserve plan assets through more protective measures, the SEC aims to protect investors by providing them with material information upon which to make informed decisions. The SEC puts the responsibility on investors to utilize available information properly and to monitor the quality of that information. The Investment Advisers Act of 1940, is the principal regulatory scheme that applies to advisery firms and the SEC is responsible for its enforcement.
The fiduciary duties imposed by the SEC are dramatically different than those fiduciary duties imposed by ERISA. Instead of providing prohibiting conflicts of interest, the SEC simply provides that such disclosures must -- such conflicts must be disclosed. Even though the SEC regulatory scheme incorporates a fiduciary concept it has been scarcely enforced and even then, it does not provide sufficient protection for ERISA plan assets.
The Center asserts that the proposed regulation, to be clear, is overly broad and we believe that the right solution is to engage the Department of Labor to engage in a comprehensive and detailed study of the proxy advisery industry. Given that your charge in the Department of Labor is to protect plan assets and those that hopefully will have a long-term value for plan participants, the Center believes that it's appropriate that the Department of Labor initiate greater oversight over the proxy advisery industry.
The Department should also provide guidance to plan fiduciaries about how to properly evaluate the information provided by proxy advisery firms which they use and rely on heavily in discharging their already established fiduciary duties of voting proxies. The Center seeks uniform and consistent treatment of proxy advisery firms as the current regulatory oversight differs based upon whether a firm is a registered investment adviser or not, and only one of the proxy firms is and that's ISS not Glass Lewis.
The Center also requests that Department of Labor prohibit proxy advisery firms from providing consulting services to corporate issuers if they also provide an independent analysis on those same companies.
Additionally, the Department should require that proxy advisery firms disclose the financial relationship with issuers so that institutional investors and pension plans can make an informed decision as to the credibility of recommendations and whether a conflict exists or not.
Thank you for the opportunity to testify here today and I'd be happy to answer any questions. And we would be happy to meet with the Department to discuss additional questions you may have.
Mr. Davis: Thank you so much, Mr. Tharp.
Mr. Berlau: Yes. If I may borrow your mic. Thank you.
I'd like to thank Assistant Secretary Borzi and members of the panel for the opportunity to testify at this hearing regarding the proposed regulation defining the term fiduciary in connection with the provision of investment advice under ERISA.
My name is John Berlau. I am the Director of the Center for Investors and Entrepreneurs at the Competitive Enterprise Institute. The Competitive Enterprise Institute is a nonprofit public policy organization dedicated to advancing the principles of limited government free enterprise and individual liberty. Founded in 1984, our mission is to promote both freedom and opportunity.
We make the case for economic freedom because we believe it is essential for entrepreneurship innovation and prosperity to flourish including prosperity for middle-class investors both in 401(ks) and other pensions and IRAs and within individual brokerage accounts.
In January, President Obama issued Executive Order 13563 intended to reemphasize the principles of President Clinton's Executive Order 12866 that governed the regulatory development and review process.
Regarding his new Executive Order, the President wrote: "We are seeking more affordable, less intrusive means to achieve the same ends, giving careful consideration to benefits and costs. This means writing rules with more input from experts, businesses and ordinary citizens. It means using disclosure as a tool to inform consumers of their choices rather than restricting those choices.
I am directing federal agencies to do more to account for and reduce the burdens regulations may place small businesses."
And unfortunately, and with all due respect, the proposed regulation we are discussing today fails to meet any of those objectives.
The proposal does not utilize in the President's words, "More affordable, less intrusive means." Instead, the proposal dramatically expands the applicability of the highest and most restrictive standard of fiduciary conduct in federal law to entire classes of market participants never before considered ERISA fiduciaries. In fact, the Department did not even consider less restrictive alternatives to the proposal in its economic analysis.
The proposal does not, in the President's words, "give careful consideration to benefits and costs." In fact, the economic analysis does not quantify costs or benefits, it admits that both are subject to significant uncertainty and that the rule could have a large market impact. And it fails to consider any impact at all on the more than 4 trillion individual retirement account marketplace.
The proposal does in the President's words, "use disclosure as a tool to inform consumers of their choices rather than restricting those choices." In fact, the proposal, we argue, would limit the choices of consumers especially in the IRA marketplace by making it difficult or impossible for consumers to keep the service agreements they now have with providers they personally selected.
Furthermore, the Department recently completed regulations, the Service Provider Disclosure Rules that will take effect next January, providing for new disclosure tools for plans and participants which could alleviate many of the concerns about hidden conflicts of interest that are said to justify the proposal we are discussing today. But the Department intends to finalize this more burdensome fiduciary rule before these disclosure regulations may even take effect.
The proposal does not, in the President's words, "account for and reduce the burdensome regulations that may be placed on small business." In fact, the Department decided it could not determine the number of small entities affected by the proposal, though the available hard data from the Form 5500 showed that 98 percent of service providers to plans with 100 or more participants have total revenues attributed -- attributable to ERISA plan clients that are below the small entity threshold.
Based on our review of this proposal and its economic justification, we are deeply concerned that the Department has failed to abide by the requirements of the regulatory process from conducting a thorough and required analysis of the impact of the regulation to denying the public a meaningful opportunity to comment on its contents.
We are also very concerned that the effect of the proposal will be to reduce the availability of choice options and freedom to individual Americans who own IRAs, to employers offering workplace retirement plans and to workers participating in those plans.
Individual choice is the hallmark of IRAs and defined contribution plans such as 401(k)s and we believe the proposal will make it more difficult for workers to get the information or advice they seek to make informed decisions.
Plan sponsors and workers should be free to select service providers on a non-fiduciary basis to assist them in making their own decisions. We believe the likely effect of the proposal would be to limit the ability of plans and workers to make that choice.
As noted by other commenters, the proposal as written will likely cause, under the may be considered standard, attorneys, accountants and actuaries who provide their services to plans to be defined as fiduciaries. As a result, the cost of the new liability of falling under this new definition as a result of that, these professionals may sharply increase their fees for these services or many may decide it's simply not worth the cost to provide their expertise to ERISA covered plans, concentrating instead on segments of the financial market that serve only wealthy investors.
Either way, middle-class workers with -- in ERISA plans would lose out as they would either be deprived of or pay much more for the skills of these professionals.
Let me try to sum up in one sentence why we are so concerned with the economic analysis in this case.
The proposal would redefine one of the fundamental concepts of an entire body of law governing roughly 10 trillion in retirement savings for the benefit of more than 100 million workers, retirees and their families.
And in our view, when the Agency is proposing to make changes on this scale that would affect so many individuals, it is incumbent on the Agency to demonstrate that it has fully considered the impact of the proposal and can, with some reasonable degree of certainty, justify the transition and ongoing costs it may impose. We do not believe the Agency has met this burden.
Economic analysis is supposed to inform and shape regulatory policy, not serve as a rubber stamp for a predetermined policy view. That's why we were very troubled to read a report yesterday quoting an Agency official saying that the testimony at these hearings asking the Department to go back to the drawing board is not going to be well received. And at the risk of not being well received, that is exactly what we request.
We believe the Department must revise, reanalyze and re-propose this rule for public comment. Let me be clear, we support the Department's effort to review this regulation and we are open to the Department's concerns about the need to revise the current rule. However, we do not believe the proposal as written can be determined to achieve the Department's goals.
In our formal comment letter we provided a number of comments for the Department to consider, but in the interest of time I will focus on a few concerns in my testimony today.
The impact on IRAs. And we acknowledge that the Tax Code gives the Department the ability to interpret the prohibited transaction rules for IRAs; however, we do not believe it would be wise to apply the proposed fiduciary definitions to IRAs.
First, as I already mentioned, the Department does not appear to have considered how this rule might impact IRAs. This alone causes concern because it is not at all clear the same cost considerations apply given the structural differences between IRAs and ERISA plans and also because IRAs hold more than 4 trillion in assets.
Second, IRAs simply are fundamentally different from ERISA plans, they are individual financial products, individual retirement accounts and should be regulated as such. Department has recognized these differences in the past as it has previously addressed prohibited transaction issues differently for plans and IRAs.
ERISA's fiduciary provisions serve to protect workers from decisions made on their behalf by others. It provides a standard of conduct and a series of rights and remedies designed to ensure that the people making decisions for you, the worker, do so in your best interest.
In an IRA, however, the individual makes her own decisions. She decides which service provider to hire and how much to pay. There is no relationship requiring ERISA fiduciary intervention to protect her interest. In effect, the actual decision-making process for the individual is the same as in a personal brokerage account or similar non-ERISA vehicle.
Applying the proposal to IRAs would have the affect of limiting her choices and second-guessing her decisions. If her IRA provider can be a fiduciary for providing her with a buy/sell/hold recommendation from the research department the provider will stop providing her with information or change its business model to comply with prohibited transaction concerns. In either circumstances, the terms of the agreement she made with her provider are now being changed because the government has decided she was not capable of making her own decisions.
We are also very concerned that the Department has relied on non-public data in developing and justifying the proposal. While the Department states that its enforcement experience leads it to take action and that the proposal is necessary to solve the Department's identified problems, the public has no way of evaluating these statements.
For example, the Department did not consider any less restrictive alternative in its economic analysis. Why? Is it because literally nothing less than the full scope of the proposal will work? The answer is, we don't know. The public is limited in understanding and reviewing the proposal until it can see and evaluate the data on which the Department relied.
Accordingly, we request that the Department provide a summary of the violations and resolution of each consultant and adviser's project investigation it undertook. The Department, of course, should redact the names of the parties involved as appropriate to protect the subjects of the investigations. Only by doing this can the public understand whether the proposal is narrowly tailored to achieve the Department's objectives based on its enforcement experience.
The Department should also develop and analyze new alternative regulations that narrow the scope of the proposal to determine if these alternatives would achieve the Department goals of less cost or greater efficiency.
In our comment letter we express concern that the Department appeared to be double counting the benefit of its prior disclosure, the service provider disclosure regulations. The concern is due to the fact that the service provider and participant disclosure regulations were never mentioned on the proposal and, in fact, on page 65365, the Preamble incorrectly states that non-fiduciary service providers, "need not disclose to the plan fiduciaries payments received from other parties without mentioning the new service provider disclosure rules going into effect."
Further, such disclosure requirements have already been promulgated by any rules by the Department, the Department's economic analysis of these regulations claim their benefits would exceed their costs because disclosure would improve decision-making and deter inappropriate behavior.
However, both these arguments are also claimed as benefits of the fiduciary proposal without regard to the other proposal. Thus, the Department should answer a question, what is the additional benefit of fiduciary status, if any, that exceeds the benefits of disclosure? This incremental benefit, if any, is highly relevant to the cost benefit analysis of the proposal.
Conclusion. We believe the regulatory impact analysis accompanying the proposal overstates the proposal's benefits and understates its costs and does not comply with the intent of President Obama's Executive Order 13563 or the previous Executive Order 12866 or OMB Circular A4. This is especially significant because of the broad scope of the proposal. We need better information demonstrating we will not be making the current situation worse by --
Mr. Davis: Mr. Berlau, are you almost finished? You're over your time.
Mr. Berlau: I am. I'm sorry. I was listening -- was the buzzer -- I'm sorry about that.
Mr. Davis: About five minutes ago.
Mr. Berlau: I'm sorry. Oh, I'm sorry. I'm terribly sorry.
Mr. Davis: Yeah.
Mr. Berlau: I'll be happy to answer if there are any questions you may have. Thank you so much.
Mr. Davis: Thank you. So, Jeff.
Mr. Monhart: Thanks, Michael. I have a question for Ms. Eller.
I understand your testimony to be that the real estate appraisers are already regulated and that they're subject to the USPAP, which is reassuring but could you tell us is there an enforcement mechanism under USPAP specifically if an appraiser does not abide by one or more the standards, what are the implications for the appraiser?
Ms. Eller: Sure. The enforcement is at the state level. All 50 states have appraiser licensing bodies. The appraisal standard -- Appraisal Institute and Appraisal Standards Boards coordinates that enforcement. They put out, for instance, guidelines that help the state regulatory bodies know what the other states are doing on enforcement for specific infractions and violations.
So it's a state level enforcement but it is very -- also very well coordinated at the federal level.
Mr. Monhart: Okay. Thank you.
Mr. Davis: I really don't have any questions but I did want to just for the record, Mr. Berlau, the official you were referring to is not here to defend herself. The quote that you made, but just to be clear, one of the reasons that we're having this hearing is to hear comments on all sides with respect to this regulation and we're open to all views no matter how much they may be in sync with what we have proposed. So just to be clear.
Mr. Berlau: And I appreciate that. I hope you will consider my recommendations -- our recommendations to revise and re-propose the rule.
Mr. Davis: We'll certainly take that under consideration. Thank you.
Mr. Strasfeld: Yes, sir.
You had -- well, I -- maybe I'm misunderstanding but you had two positions that seemed to be seemed to be somewhat in conflict at least to my understanding. You said the reg is over broad, which I understood. You said the same thing. But then you focused more narrowly on these proxy votes advisery companies that service pension plans and other institutions who want to be given direction as to how to vote their proxies.
So I understand that your -- the concerns you expressed with respect to those institutions but -- which is a -- kind of a narrow focus, but what is -- what is your focus as to why the reg is over broad?
Mr. Tharp: Yeah. The -- our members who are in the Center are also sponsors of ERISA plans and for many of the reasons that have been indicated that it would implicate people who just provide information and nothing more, would be concerning fiduciaries. And the fear is that it would increase the costs and let's say, voluntary benefit system.
And, as you know, there are -- there's this tension of wanting to make sure that we're providing benefits but at the same time being conscious of cost.
The other is to have access to valuable information and if it precludes the ability to access people who heretofore have provided that information but weren't deemed to be fiduciaries, it would probably be to the disadvantage of firms trying to maintain these plans.
Mr. Strasfeld: Because the -- I think the proposal goes to some extent to make it clear that investment, education and that type of information will continue to be non-fiduciary in nature.
So is there -- is there information you're concerned that -- that's sort of in between investment advice? I mean, what would be an example of something that seemed okay in the past but might be problematic under this proposal?
Mr. Tharp: Yeah. When I actually served on a pension committee when I was -- a board appointed pension committee when I was head of human resources in a company, I would have various employees provide information to me that would inform some of my voting and my decisions on the committee. And the questions would be would those people now be considered to be fiduciaries if they're providing that information and nothing more?
And you might imagine the implications of that for how we would treat not only potential liability of employees and to cover them, but just the -- the issue of who we could turn to get information without inadvertently pulling them into the coverage of being a fiduciary.
Mr. Strasfeld: Ms. Evans.
Ms. Evans: Ms. Eller, with respect to your point about impartiality. If the reg made clear that appraisers aren't expected to slant their valuations or opinions one way or the other, would that allay some of your concerns about the reconciliation between being a fiduciary under ERISA and applying with some of the rules under the Code?
Ms. Eller: I think it would help, but I think up to now appraisers have not been considered fiduciaries in part because their information is individualized as to the needs of the plan and doesn't take into account the sort of broader range of things that a fiduciary making a decision that's maybe based in part on an appraisal is -- has to take into account.
So the objectivity piece would help but I think they'd still be concerned about co-fiduciary liability and they'd still be concerned with sort of the nuts and bolts of how you reconcile. Now I've got three things to reconcile, the USPAP standards, the kind of fiduciary light, objectivity is okay, if you're an appraiser type fiduciary and the standard 404 and 406.
So I think it would be a step in the right direction but I'm not sure it would solve the concerns.
Ms. Evans: And what is your understanding of the ability of a participant in a plan to be able to bring an action against an appraiser? Some previous witnesses said well, trustees can always bring an action in state court, there's already enforcement actions again appraisers. What's your understanding of a participant to be able to bring an action if they believe that an appraisal is inadequate or do you believe that participant should be able to bring actions in court if they believe that inadequate appraisals led to losses to plans?
Ms. Eller: Well, I think the structure that ERISA has set up is that participants have the ability to bring an action against a fiduciary who's breached their duties. And the person who's responsible for keeping watch over the participants -- the participants' money is the fiduciary who's responsible for hiring the appraiser or purchasing the asset. So I think that's the structure that's been set up for participants.
As to whether participants could bring an action in state court directly against an appraiser for a faulty appraisal, I think there might be some -- some difficulty in that given that the appraiser and the participant don't have any direct relationship, but I think there's an awfully good proxy for participants who are concerned about a fiduciary having relied on a poor appraisal.
Ms. Evans: So you think it will be appropriate for a participant to be able to bring an action against appraiser in state court?
Ms. Eller: Well, I guess I don't know why they'd need to. They've got a fiduciary in front of them.
Ms. Evans: Mr. Berlau, do you have any -- I guess -- you kept saying that the reg constricts choices for investors in the IRA market. Do you -- what's the basis of that statement?
Mr. Berlau: I think the basis is just if an IRA provider were a fiduciary and had to do the -- with the definition of the highest standard of what is the - - I know it's slightly different from the SEC definition of single best interest there might be some different types of products, things like that that may not meet that standard that -- where the individual would still want -- they might not be able to provide.
Mr. Piacentini: Okay. I would like to thank Mr. Berlau for helping highlight some of the areas where we can strengthen the impact analysis that we've undertaken so far. I do think that you've pointed some places where we really would benefit the public by further explaining some of our thinking and maybe digging deeper in some places, so thank you for that.
I do want to get on the record by way of observation that, you know, certainly it is our intention to satisfy the requirements of the applicable Executive Orders and other applicable requirements when we do our analyses and I think we crossed that threshold this time but that doesn't mean that there's not always room for improvement. So I do thank you for that.
You know, I think certainly for those who have looked at the economic analysis, we do confess to some uncertainty there, both with respect to cost and benefits of this proposed rule and, in fact, that's something we're supposed to do under the applicable requirements is point out where some of the uncertainties are. So to the extent that you or any of the others who we've heard from today can help us resolve some of those uncertainties, that's always, always helpful.
So I guess I'll just -- I'll just highlight one dimension of that invitation, if you will, where I would like to encourage everybody who can to help us out. Certainly, you know, the question of -- that's being investigated now in behavioral economics and other strands of literature about how you deal with business relationships where one party has more expertise or more information than the other party. It's an area where our research is still evolving.
There's some disagreement, I think, about how much disclosure by itself can protect a consumer when they're dealing with an expert. In fact, there's some research that -- I won't go into the details right here, but there's some research that suggests that disclosure science can be counter-productive. So there's a lot to consider.
So that's what we're struggling with. I think that we have drawn some reasonable conclusions based on the information available to us. But to the extent we can have better information and draw firmer conclusions, I'll be very happy.
So I'm sorry, that probably seemed more like an observation than a question, but I do invite you if there's anything that you'd like to share at this point to help us with that, that would be great.
Mr. Berlau: Well, thank you. And thank you and we will be happy to provide you some more information and some more suggestions after the hearing if you'd like to hear from some more of us.
I would just say that a lot of this involves -- involves disclosure, not just to the plan participants but to the administrators, the sponsors of what a broker/dealer or an attorney can -- accountant can provide there. And they're already the experts and they have the fiduciary duty on behalf of the worker.
So maybe having something where the same investor education exemption applies to the worker where it also applies on the level of the service providers to the plan administrator where if it's simply general education that could -- for the administrator as well as the worker and that in turn it gets passed on. That could -- that could help solve this problem and benefit the workers as well.
Mr. Piacentini: Thank you.
Mr. Berlau: I think Great West Insurance Company suggested something along those lines in its comments.
Mr. Piacentini: Thank you.
Mr. Wong: I just have one follow-up question for Ms. Eller. It's sort of a follow-up to your earlier question about state law causes of action against an appraiser.
My question is in the context of say the plan fiduciary who got the appraisal report and relied on it. What's the nature of the state law cause of action? For example, is it state -- some professional malpractice suit? Is it some contractual claim? And if so, would the appraiser be able to utilize something like a hold harmless clause to effectively have the fiduciary waive any potential liability or cause of action?
Ms. Eller: I think I got all that.
Yes, I think there are contractual claims and the equivalent of appraisal malpractice claims. There's also the economic reality which is appraisers who don't do a good job, don't get hired again, which is, I think, a very much a factor that we should pay attention to.
And then the second part of your question specific to the hold harmless clause, I mean, I think the Department's guidance to fiduciaries on indemnification and disclaimers of liability when they're hiring non-fiduciary service providers would hold true here. I think what that guidance says is there's nothing per se imprudent about hiring a nonfiduciary service provider and limiting their liability; however, the standards under which they should provide services that the disclaimer standards shouldn't include things like gross negligence, fraud and willful misconduct.
And I would say that would be a good guidance here and is applicable.
Mr. Wong: Okay. Thank you.
Mr. Davis: Thank you.
We'll call the last panel. Panel 13. Lucky 13 in this case.
The last panel includes Marta Bascom, with the National Retiree Legislative Network. And Charles Yocum and Justin Tomevi.
Panel 13, we appreciate your stamina. And welcome to the Panel. So I think we'll start with Ms. Bascom.
Ms. Bascom: Thank you. Thank you all very much.
This is a very important issue for the retirees who are members of the National Retiree Legislative Network. For those of you who aren't familiar with the NRLN, it is a non-partisan grassroots coalition representing over two million members, retiree members from 30 retiree associations as well as individual members.
Our members have retired from 125 U.S. companies and public entities. They have grave concerns about present and future retirees' financial security with particular trepidation about the state of their pension plans now and in the future.
The NRLN strongly supports EBSA's efforts to update the scope of ERISA's fiduciary duty protections and specifically the proposed rule on the definition of the term fiduciary.
The changing marketplace has made several aspects of the current regulatory structure obsolete and ineffective. EBSA's proposed changes are necessary to provide needed protection for pension plan participants.
The NRLN applauds these efforts and thanks the Assistant Secretary and the entire staff for moving forward on this issue. But the NRLN also remains hopeful that this proposed rulemaking process will take into consideration the increasing role of foreign fiduciaries in this global marketplace.
The NRLN believes that the definition of the term fiduciary as proposed must be expanded in this proceeding or one in the near future to address situations where fiduciary duty is breached by a foreign fiduciary and results in depleted plan assets. Specifically, the NRLN recommends that the proposed rule include a requirement that at a minimum, all named fiduciaries under ERISA be subject to the jurisdiction of U.S. District Courts with respect to the enforcement of judgments for potential breaches of fiduciary duty.
In addition, named fiduciaries should be held jointly liable for the fiduciary breaches of other fiduciaries who they designate under section 405(c)(1) and who they know or reasonably should have known are not subject to the jurisdiction of U.S. courts for the purpose of enforcing judgments under ERISA. Increasing globalization dictates that this should be so. The environment has changed dramatically since the rules defining fiduciaries were originally established. In the 1970s, the marketplace in the U.S. was still largely comprised of U.S. based companies with assets and fiduciaries in the U.S., all within the jurisdiction of our courts.
The expansive globalization of the marketplace was not envisioned then. Now, globalization through mergers and acquisitions has changed the makeup of fiduciaries charged with the care taking of the pension plan assets of millions of retirees in this country.
We are increasingly seeing more and more foreign companies merging with or acquiring U.S. companies with pension plans and more will be coming.
As part of a common business strategy, for example, foreign entities often strategize to combine pension plans into similar businesses they acquire in the U.S. in order to leverage the management of combined assets. These actions magnify the potential impact of an arm's length foreign fiduciary and thus the need to make named fiduciaries subject to U.S. legal jurisdiction.
Within the NRLN's membership, retirees have seen this with the acquisition of Lucent Technologies by France based Alcatel. In addition, there are numerous media accounts of foreign entities looking to acquire U.S. companies in the technology sector and the automotive industry just to name two. Those are just examples from among the former employers of NRLN members. Examples of other U.S. companies that have been acquired over the last three decades are too numerous to name here.
The fact is that the regulatory structure currently in place does not address the realities of the global marketplace nor the vulnerability of U.S. plan participants should there be a breach in the foreign fiduciaries duty. Unless our government examines the current regulatory structure with a proactive strategy, U.S. plan participants remain dangerously vulnerable due to the lack of legal recourse.
Under these circumstances, it is an incomplete exercise to determine that an individual or a firm is an ERISA fiduciary and liable for breach of fiduciary duties if that party is not required to be subject to the jurisdiction of U.S. courts. Liability for breach of fiduciary duty is a clear objective of ERISA. That objective is circumvented if a fiduciary is not subject to the jurisdiction of U.S. courts.
In addition, without enforceability in U.S. courts a foreign buyer of a U.S. entity with pension obligations can circumvent ERISA's protections by simply locating beyond the reach of U.S. courts, thus insulating a bad actor from legal action. Without this additional protection foreign fiduciaries are able to participate in management decision to move fungible assets offshore, out of the reach of U.S. bankruptcy courts, thus making such assets unavailable to be liquidated and applied to highly under-funded U.S. defined pension plans.
Including this requirement is not a far reach when considering the rationale Congress devised for establishing the regulatory framework for ERISA at its inception. The prospect of holding named foreign fiduciaries liable for missing assets due to a breach of fiduciary duty is consistent with the congressional intent of maintaining the indicia of plan asset ownership under the jurisdiction of Federal District Courts.
As you know, section 404(b) of ERISA prohibits a fiduciary from maintaining plan assets beyond the reach of U.S. District Courts. While Congress in 1974 could not foresee a situation where named fiduciaries could be foreign nationals beyond the reach of our courts it is highly likely that those same lawmakers would see the consistency in requiring all named fiduciaries to be subject to Federal Court jurisdiction.
The goal of the two requirements would be the same, to have the law allow for both obtaining and enforcing judgments in all cases where a named fiduciary is found to be in breach of duty in order to protect plan participants.
The U.S. government, through the Department of Labor and the PBGC needs to have the ability to rely on the jurisdiction of U.S. Courts to enforce judgments against breaching fiduciaries acting on behalf of a foreign entity. Specifically, they need the ability to both obtain and enforce judgment in an action for fiduciary breach against any fiduciary not just those that choose to maintain sufficient assets within the jurisdiction of U.S. Courts.
Recent upward trends in foreign acquisitions and in spin-offs of divisions of U.S. based firms to foreign based investors will become more common and plans arising after these transactions resulting in foreign fiduciaries will increase as well. That will pose a significant challenge to both the Department of Labor as well as the PBGC if they are unable to hold at least all named fiduciaries accountable in U.S. Courts.
Perhaps most importantly for retirees, plan participants rely on the ability of U.S. courts and regulators to enforce judgments and to deter bad actors. This is an essential protection for plan participants. In fact, the Department of Labor website advises plan participants that they may bring a civil action in court to among other actions, attain appropriate relief from a breach of fiduciary duty.
In general, this private right of action has greatly benefited plan participants in both providing access to U.S. Courts as well as in deterring potential bad actors. This private right of action should be available in cases of breaches of fiduciary duty against all named fiduciaries regardless of nationality.
The global marketplace has created a new paradigm which calls for the U.S. government to continue to provide the same standard of recourse and deterrence with a progressive framework to protect plan participants and indeed millions of retirees from losses that can have a devastating impact on their already fragile financial security.
I thank you all very much for this opportunity and look forward to working with you and answer any questions you may have.
Mr. Davis: Thank you, Ms. Bascom. Mr. Yocum, Mr. Tomevi, is that the way to pronounce it?
Mr. Tomevi: Right.
Mr. Davis: Is that correct?
Mr. Tomevi: Yes.
Mr. Davis: Okay. Thanks.
Mr. Yocum: Thank you for allowing us the opportunity to speak today. My name is Charles Yocum and I am here today with my classmate, Justin Tomevi. Both Justin and I are students at the Earle Mack School of Law at Drexel University.
We share an interest in the issues related to employee benefits and are working on a research project on the meaning of fiduciary under ERISA.
Prior to law school, I spent eight years working in the retirement services industry, seven of which with one of the nation's leading retirement service providers, although we are testifying here on our own behalf.
We'd like to use our allotted time to address an issue raised by the Department in the Preamble of the proposed regulations, that is, whether and to what extent the final regulation should define the provision of investment advice to encompass recommendations related to taking a plan distribution.
We believe the final regulation should treat such recommendations as investment advice. Doing so will further the Department's stated desire to protect participants from conflicts of interest and selfdealing. Furthermore, it may be important for the Department to use its enforcement powers in this area because there may be limits to the effectiveness of remedies that a participant can obtain a private civil action under ERISA.
Recommending to a participant that he or she take a distribution from a plan could harm the participant's interest in a variety of ways. Most employer sponsored retirement plans provide payment options that would not be available to the participant outside of the plan. While it is true that the retirement community has drastically changed over the past 35 years the joint and survivor annuity remains the default payment option for all defined benefit and defined contribution money purchase plans.
In addition, as of 2007, an additional 21 percent of 401(k) plans also offer an annuity option to participants.
Advising participants to forego an investment that would ensure them against longevity risk is a type of investment advice and should be treated as such.
Another relevant consideration for some participants is that under Code section 72(t), a participant who has attained the age of 55 and has separated from service can avoid the 10 percent early withdrawal penalty, an option that would be unavailable if the same distribution was made from the IRA.
Another important change in the industry is that as the baby boom generation begins to retire, financial service companies are facing the prospect that more money will be paid out, employer plans need to be replaced by the inflow of new contributions from younger workers. For an industry that seeks to maximize assets under management, this shift has presented some service providers and some financial planners to encourage terminating participants to invest their accounts in proprietary assets.
The Department has previously stated that when a non-fiduciary advises a plan participant to request an otherwise permissible plan distribution, such a recommendation does not constitute investment advice under the existing regulations. We think it appropriate that the Department revisit this position in light of the proposed regulation.
Some may argue that advising a participant to roll over her retirement account balance to a like investment simply is not investment advice. Even assuming that the participant would not be forfeiting the annuity option or the plan by doing so, we would suggest that in many cases, such recommendation should still be considered investment advice. In many cases the assets of an employer sponsored retirement plan might be invested in low fee institutional shares as opposed to relatively higher fee retail shares often found in an individual retirement account.
In addition, the administrative costs related to assets left in the plan will often at least partially be subsidized by the employer. Others may argue that the -- that by providing distribution advice, serious providers can alleviate the problem of leakage by retaining retirement savings and a deferred -- tax deferred retirement account. Leakage is most pronounced when a participant's employment status changes and by intervening early, service providers are in a position to help the participant maintain their retirement savings in some kind of tax advantaged investment vehicle.
While efforts to prevent pre-retirement cash distributions are laudatory, there is no reason why this cannot be accomplished through a program of rigorous investment education consistent with what the Department outlined in Interpretive Bulletin 96-1.
Moreover, we think that the Department could clarify through guidance or in the Preamble to the final regulations that advising an individual participant to consider retaining assets in a tax deferred solution when the participant plans to take a lump sum distribution without attempting to sell the participant on particular products is itself -- is in itself investment education rather than investment advice.
We're not advocating that serious providers be prohibited from recommending that participant request an available distribution from his retirement plan or how those proceeds should be reinvested. However, we do believe that the final regulation should deem anyone providing such advice to be an ERISA fiduciary for purposes of the transaction. By doing so, the Department can encourage serious providers to provide distribution advice as prudent and in the interest of the participant.
Mr. Tomevi: Hello, my name is Justin Tomevi. As Charles has explained, we urge the Department to regulate distribution advice as investment advice because of the profound impact it has on retirement security.
A reclassification should be considered in the context of judicial decisions that may make it difficult for participants to obtain meaningful relief, to redress harms caused by conflicted distribution advice.
There are two obstacles to such relief. First, once investment assets are moved from a plan to an individual retirement account, they may no longer be plan assets and thus, subsequent losses may not be addressable under section 502(a)(2) of ERISA.
Indeed, this appears to have been the primary basis for the Department's position in the Advisery Opinion 2005-23A in which it wrote that the proceeds of a distribution would be advice with respect to funds that are no longer assets of the plan.
Second, it may also be difficult for a participant to obtain meaningful equitable relief under section 502(a)(3) to redress harms such as investment loss or the higher cost of annuitization outside of a plan.
We suggest that the Department in thinking through these remedial problems consider the thoughtful District Court Opinion in Young v. Principal which is cited at 54 -- 547 F.Supp. 2d, 965, a 2008 Iowa case. In Young, retiring participants received a letter from the Principal Financial Group instructing them to take immediate action because changes in their employment status affected their retirement account. The participants contacted the 800 number on the letter, which directed them to sales counselors who were required to solicit the high fee plan which resulted in plaintiffs earning less than if they maintained their original plans.
The District Court held that only appropriate equitable relief was available to the participants. So participants could not receive compensation for their lost opportunity or profits they would have achieved if the funds remained with the original plan.
However, the court took an important step by holding that if the sales counselors were fiduciaries and they breached their duty the participants could pursue disgorgement of Principal's profits and transfer their accounts back into the original plan.
While this was an important step, participants may still not be made whole as a disgorgement remedy will not reach lost opportunity, just the financial service providers' fees. As a result distribution advisers still may not have significant incentives to halt strong and perhaps misleading sales pitches that target important sources of retirement income for participants and their spouses.
Moreover, the remedy presumably would be available only in cases where a participant's plan is willing to accept back the participant's distribution, which can be particularly problematic in defined benefit plans. But the District Court's holding that disgorgement in a return of assets to the plan is a form of equitable relief may also have implications for the first question, whether the plan continued to constructively hold the assets and thus, the assets remained plan assets even after distribution.
In any event, given the potential obstacles, the courts fashion a meaningful relief for participants, we believe it is important for the Department to monitor this area and use its own enforcement powers when appropriate.
I want to conclude by noting, as the Supreme Court recognized in LaRue and the Department of Labor recognized in the Preamble to these proposed regulations that the employee benefit landscape has changed from the 1974 enactment of ERISA and the rules should evolve to reflect those changes. The personalization of defined contribution plans and the power and risk shift to individual participants requires better and equally important unbiased advice.
We urge the Department to take steps to ensure that distribution advice is treated as investment advice and to consider how the Department can ensure that participants do not have a right without a remedy.
Thank you for giving us the opportunity to speak with you today and we'll be happy to answer any questions.
Mr. Davis: Thanks so much. We'll turn to the government panel starting with Jeff.
Mr. Monhart: I have no questions. Thank you for your testimony.
Mr. Davis: Okay. I just want to recognize the students here. It's the first panel I've been a part of where we've actually had students testify. I just think it's terrific that you're willing to step forward and express a point of view on the record as students. I just think that's absolutely terrific.
Now, you said that the fiduciary definition is the topic that you're looking at as part of your overall prac -- I'm just curious, how did you happen to select that topic among other things that you could have looked at in this area?
Mr. Yocum: Well, I think for one it's topical. I mean, it's -- these hearings were -- we're in an employee benefits course together and we started a month ago that this is in the news, it's something at least, I mean, interested both of us.
Mr. Tomevi: Yeah, I think Charles -- some of Charles' background working in one of these organizations also kind of allowed him to see the other side and see both sides in this case.
Mr. Davis: Ms. Bascom, you focused primarily on the foreign jurisdictional issues. Were there any other thoughts you had with respect to the Regs, any other issues that we asked about up -- one of the areas we asked comment around was this issue of this rollover advice. Any perspective there as well?
Ms. Bascom: No, not at this time, but we are very supportive of the proposed rule and just again, feel that it needs to be expanded to make sure that plan participants are fully protected.
Mr. Davis: Thanks.
Mr. Strasfeld: I just have an observation for Ms. Bascom. I'm in charge of the EBSA's Office of Exemptions and the issue you raised, which I think is a great issue, has been relevant to our consideration of a lot of exemptions where there are foreign affiliates. And we've attempted in a number of instances, especially we've provided 406(b) relief to make someone responsible in the U.S..
So, I mean, one possibility is we routinely have the foreign entity agree to submit to jurisdiction of the U.S. Courts to be served here, but in instances where there's actually fiduciary issues we generally try to have someone who we could sue here or agrees that if there's liability, you know, the American affiliate will pay as a way of -- I guess the way we're looking at it the plan should not have to go overseas to sue. It works out a lot better -- obviously, you know, you have ERISA here in Federal Court so we try to structure an exemption where that happens and I think we've been successful in a number of cases.
But you're right, it is an important issue. It's one we will consider in the future.
Ms. Bascom: Thank you. We appreciate that.
Mr. Strasfeld: I appreciate you bringing it up.
And great to see you too.
Mr. Yocum: Thank you.
Ms. Evans: Mr. Yocum and Mr. Tomevi, one of the witnesses from one of the financial institutions yesterday testified that they have a number of reps in these call centers and so a participant might call up and say, you know, what are my options? And it seems like you too would support just generally being able to say these are your options, these are your tax consequences if you leave your money in the plan, if you roll it over. It seems like you all are saying that that should be investment advice. Is that correct?
Mr. Yocum: That -- in -- I'm just going over the, you know, tax consequences what the process is, yeah, I would argue that is investment advice. But I still don't see why, I mean, again, we're not saying that they -- that they shouldn't be giving, you know, be steering these individuals into a product outside of their 401(k) plan if that's what they're looking for. It's just that you do it in a way that's prudent and in the interest of the participant.
Ms. Evans: Right. So at the point when a rep at one of these call centers says, well, are you interested in learning more about how to take advantage of, sort of --
Mr. Yocum: X, Y --
Ms. Evans: -- rollover. At that point, you would say, well, that's crossing the line from education to investment advice?
Mr. Yocum: Yes.
Ms. Evans: Thank you.
Mr. Piacentini: I have no questions.
Mr. Davis: Anything else from the panel? Nothing? Okay. Well, thank you Panel 13, our last panel. And thank you for the audience for your attention through the last two days of testimony.
Just a few administrative announcements.
One is that we, the government panel, may have additional questions for some of the witnesses, which if we do we would submit for the record, get the responses on the record.
And speaking of the record, the record will be open an additional 15 days after the hearing so if there's supplemental materials, clarifications to testimony that's been provided, you'll have 15 days to do that.
We are going to post the transcript of these proceedings on our website and it should be up in about two weeks.
So with that, we're going to conclude and thank you so much for your time.
(Hearing concluded at 2:18 p.m.)
Certificate of Notary Public
I, Natalia Kornilova, the officer before whom the foregoing meeting was taken, do hereby certify that the witness whose testimony appears in the foregoing pages was recorded by me and thereafter reduced to typewriting under my direction; that said hearing is a true record of the proceedings; that I am neither counsel for, related to, nor employed by any of the parties to the action in which this hearing was taken; and, further, that I am not a relative or employee of any counsel or attorney employed by the parties hereto, nor financially or otherwise interested in the outcome of this action.
My commission expires: April 14, 2012