Now that the initial 408(b)(2) disclosures are out, the challenge becomes understanding them. Beyond just understanding whether or not the fees disclosed are reasonable (a challenge in itself), the disclosures do something arguably more important: they take us behind the looking glass, opening a window to a world with which most are not familiar, but which is critical to the operation of 401(k) and 403(b) plans. The disclosures provides hints to, and sometimes disclose, the complex series of relationships and financial arrangements which make possible the daily trading and investing of the assets in individual account plans, on both NAV and insurance platforms, and the manner in which those parties involved in those relationships are paid for those services.
 What this new view reminds us of is that 408(b)2 is but one (albeit important) part of the entire scheme of prohibited transaction rules.  There are a myriad of other prohibited transaction exemptions that are necessary to make the system work. Everything does not begin and end with the “covered service provider”: though all CSPs will be “parties-in-interest” and “disqualified persons” (under the Tax Code’s version of the prohibited transaction rules), not all “parties-in-interest” and “disqualified persons” are CSPs. And many of these non-CSPs will pop up during the 408b-2 disclosure process.

The “simple” payment of 12b-1 fees to a broker dealer is a prime example.  Assume a 401(k) trust has purchased a mutual fund share which pays 12b-1 fees, and assume a registered rep made the sale.  The trust will be a CSP to the plan, but the investment company, through the purchase of the mutual fund share, is not. The mutual fund share is merely an investment asset of the plan, under which no services are provided under ERISA 408(b)(2). Further, there is no “look thru” to the dealings of the underlying assets of the mutual fund.

The mutual fund itself is an interesting creature. It is an investment company which typically has no employees.  In order for it to pay the 12b-1 fees which are generated by the 401(k) plans’ purchase of a share, it usually has an arrangement with a fund distributor or a transfer agent (or both), to which it will pay the 12b-1 fee. These fees are authorized to be used for the specific purposes outlined by the mutual fund’s board in its adoption of its 12b-1 program, and it is for servicing the mutual fund, not the 401(k) plan which purchased the share.

That fund distributor is not a CSP, as it provides no services to the plan, and is not a 408(b)(2) subcontractor because the mutual fund to which it provides services is not a CSP (and there is a specific exception in the regs for those which provide the sorts of services fund distributors provide to investment companies).

The fund distributor will then have a selling agreement with the broker-dealer which sells the mutual fund shares, under which the 12b-1 fees are paid to that broker dealer.  That broker dealer then has a registered representative agreement with the selling broker, under which it agrees to pay to that rep a certain percentage of the 12b-1 fees it receives.

Though the fund distributor, the broker dealer and the registered rep are all receiving indirect compensation from the plan, absent any thing else, they are not CSPs or subcontractors to CSPs. They are paid under a contract for 12b-1 services to the mutual fund, not the 401(k) plan.  Therefore, no 408b-2 disclosure would need to be made of this compensation under this set of facts.

Arguably, once a rep and a broker dealer receive the 12b-1 fee, they may become a party in interest to the plan, even though they may not otherwise be a CSP. In that event, the payment of future commissions (being indirect compensation) would become a prohibited transaction unless there is a prohibited transaction exemption, which there is. PTE 84-24 permits a rep to receive a mutual fund commission if it is disclosed (much like 408(b)(2)) beforehand.

I provide this example only as an illustration, as it is very often not as simple as this. In this type of arrangement, there is often an affiliated party which IS providing services to the plan, whether as a plan trustee, a TPA or an advisor, which then changes the entire formula. And some may take issue with the thought that the b/d and rep are not CSPs, and others may take issue with the payment of a commission as creating party-in-interest status. All are legitimate points. On top of everything else, these determinations are notoriously fact-specific.

But the point is that these complex relationships now become a much more open part of the fiduciary mix.

For your reading pleasure, by the way, is the Investment Company Institute’s description of how intermediaries work in this chain described above. It is useful reading. Note that it is a 2009 document, and technology (and the market) continues to shift many of these relationships and arrangements. Note, also, that an analysis involving the purchase of variable annuity contracts by plans is substantially different than the one described above.

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