In late August, the U.S. Department of Labor ("DOL") announced that it had reached a settlement with USI Advisors (a Goldman Sachs subsidiary, hereafter referred to as "USI") to pay $1.27 million to 13 defined benefit pension plan clients for alleged violations of the Employee Retirement Income security Act of 1974, as amended ("ERISA"). The trouble related to USI's failure to "fully disclose" receipt of 12b-1 fees paid by mutual funds over a 7-year period ending in 2010 and to use them for the benefit of the plans. The DOL announcement of the settlement stated that investment advisers acting as fiduciaries (presumably, including USI) cannot use their fiduciary authority "to receive an additional fee or to receive compensation from third parties" for the adviser's account.

So what went wrong here? Was it that USI didn't disclose the 12b-1 fees it was getting (which was not illegal at the time), or did it use its position as the plans' investment adviser to increase its own compensation by recommending investment in mutual funds that would pay USI these fees? ERISA's prohibited transaction rules require plan fiduciaries to limit their compensation to level fees in order to prevent such a conflict of interest from harming the plan.

USI's View. For its part, USI has indicated that all its revenue was disclosed and that it received the 12b-1 fees in lieu of any "commission." According to USI, it was all just a procedural issue with the DOL deciding that for defined benefit business, the 12b-1 fees should have "flowed through the plan." This made it sound like the arrangement was simply an unusual form of ERISA account (see discussion below) in which all of the indirect compensation credited to the account was used to offset fees owed to plan service providers, except that in this case there was no stated amount of fees, and it was agreed that USI would be fully compensated from the 12b-1 fees.

12b-1 Fees and Revenue Sharing. So-called revenue sharing payments, such as 12b-1 fees (and their cousin, sub-transfer agency fees), compensate a service provider, such as USI, for activities (typically recordkeeping or accounting) on behalf of the mutual fund or the plan. Plan fiduciaries must evaluate what the provider does in relation to both this indirect compensation and any compensation that is paid directly by the plan sponsor or the plan. Until recently, many plan administrators knew little to nothing about the indirect compensation and, as a result, may have authorized direct compensation that, when added to the indirect compensation, was more than what a reasonable person would have believed the services to be worth.

To make matters worse, some savvy plan sponsors selected mutual funds with more revenue sharing so that the costs of the plan would not be seen by the participants who were ultimately paying these charges by reduced returns on their plan investments. This is what happened in the recent Tussey v. ABB, Inc. case where the plan sponsor incurred a $13.4 million judgment attributable solely to its lack of concern in monitoring such payments.

Revenue sharing is of less concern in a defined benefit plan where the employer is on the hook for any shortfall resulting from poor investment performance and is presumably looking out for its own interests. However, this did not seem to matter in the USI case.

Effect of New Fee Disclosures. The fee disclosure regulations which went into effect last July are intended to eliminate the obfuscation that can be caused by revenue sharing. Under these regulations, in general, the service provider must disclose three things: the services it will provide, whether it is a fiduciary or registered investment adviser (such as USI) and how much money it will get for performing these services, whether in the form of direct or indirect compensation. Each of these elements is incorporated in the USI settlement along with the requirement to incorporate such terms in a written contract or letter of understanding, but only in those service arrangements where actuarial and investment advisory services are bundled together. So other than the monetary aspect of the settlement (which did not include a penalty), the settlement terms do not go much beyond what the current regulations would have required in any event.

ERISA Accounts. To fully understand what must have been bothering the DOL about USI's fee arrangement, we must return to the idea that it was similar to a so-called ERISA account (sometimes referred to as an ERISA budget or an ERISA expense account). Where such an account is used, some or all of the indirect compensation paid with respect to a plan is placed in a special account which may be used to compensate a plan service provider. In one version of this arrangement, the account is part of the plan assets and is shown as such on the plan's Form 5500. If it is not zeroed out at the end of the year by the payment of compensation to service providers, the plan allocates the remainder to participants.

In another version, the ERISA account is part of the assets of a financial institution, such as USI, and does not belong to the plan. The plan may, however, direct the financial institution to use the assets in a number of ways, as specified by agreement, including the compensation of providers. If the plan discontinues the services of the financial institution, the account is usually forfeited. In other words, the financial institution gets to keep the account balance.

Fixed Fee Requirement. The second type of account seems to have been used in the USI case and the DOL objected to the fact that there was no limit on the portion of the account that could be retained by USI. If USI had specified a dollar amount as its fee and agreed to contribute to its plan clients all revenue sharing credited to the ERISA account in excess of that fee, all would have been well. Without such a limit, however, USI had an incentive to invest plan assets in those mutual funds that paid the highest 12b-1 fees in order to reap the highest possible fees.

The rules for ERISA accounts are not entirely clear, and it is rumored that the DOL has guidance in the works. This and the fact that the plan sponsors may have been willing accomplices probably contributed to USI's getting off relatively lightly for what might have been treated as a prohibited transaction. Instead, the DOL news release announcing the settlement categorized USI's fee practices as an "alleged violation" of ERISA. One's view of the harshness of such a settlement depends on where you sit, however, and the return of over a million dollars in fees would be an unwelcome event for most service providers. The moral is that advisers and their clients should agree on a level fee (a specific dollar amount or a percentage of plan assets) in advance of any compensation arrangement utilizing the type of ERISA account employed by USI.