The Department of Labor’s Prohibited Transaction Exemption and Its Impact on Recommendations to Plans, Participants and IRAs (Part 6)

On February 16, 2021, the DOL’s prohibited transaction exemption (PTE) 2020-02 became effective. The PTE is titled “Improving Investment Advice for Workers & Retirees.” (https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12208.pdf)  It allows investment advisers, broker-dealers, banks, and insurance companies (collectively referred to as “financial institutions”), and their representatives (collectively referred to as “investment professionals”), to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to retirement plans, participants and IRA owners (collectively referred to as “retirement investors”).

In the preamble to the PTE, the DOL also announced an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals will become fiduciaries and therefore need the protections afforded by the exemption. In addition, they will need prudent, or best practice, processes to satisfy those standards of care.

In order to obtain the benefit of the exemption, financial institutions and investment professionals will need to satisfy the “conditions” in the exemption. For the period from the effective date (February 16 of this year) until December 20 of this year, the DOL and IRS non-enforcement policy on prohibited transactions resulting from non-discretionary recommendations will stay in place. That is, neither the IRS nor the DOL will enforce the rules against transactions with plans, participants or IRA owners that are prohibited in the Code or ERISA (that result from nondiscretionary recommendations), so long as the Impartial Conduct Standards are satisfied. The Impartial Conduct Standards are: the best interest standard of care, the limit on compensation to reasonable amounts, and a prohibition of materially misleading statements. Note, though, that this only binds the DOL and IRS. The non-enforcement policy does not limit private claims that otherwise exist in the law (e.g., ERISA).

This article builds on the earlier posts, Parts 1-5, Best Interest #36, #37, #38, #39 and #40. My last article (Best Interest #40) and the ones that follow discuss interesting, and perhaps lesser known, issues in the exemption.

It has been well publicized that the exemption and the associated expansion of the definition of fiduciary advice will have a significant impact on recommendations by investment professionals (such as individual investment advisers and representatives of broker-dealers) to retirement plan participants to make rollovers to IRAs. But, as explained in my last article, there is more to the meaning of “rollover” than might be imagined. Here’s a summary of what the DOL labels as rollovers:

• A recommendation to take a distribution and transfer it to another plan (as a direct or indirect rollover).
• A recommendation to take a distribution and transfer it to an IRA (as a direct or indirect rollover).
• A recommendation to transfer money from an IRA to a plan (as a direct or indirect rollover).
• A recommendation to transfer money from an IRA to another IRA (as a direct or indirect rollover).
• A recommendation to transfer money from one type of account to another (g., from a commission-based account to a fee-based account). The DOL and IRS would only have jurisdiction over those transfers if they are within a tax-qualified or ERISA-governed account (e.g., an IRA, a plan or a participant’s account).

Let’s look more closely at examples of the two highlighted types of transactions:  recommendations to transfer IRAs from one firm to another, and recommendations to transfer from a commission-based account to a fee-based account.

I imagine that it is fairly common for an investment professional to recommend that an investor transfer his or her IRA from another firm to the investment professional’s firm. In that case, and until December 20, 2021, the investment professional (and the financial institution) only need to satisfy the Impartial Conduct Standards (ICS) in making the recommendation to be protected from the DOL and IRS asserting a prohibited transaction. If the financial institution and the investment professional satisfy the best interest standard in Reg BI, that should also satisfy the best interest standard in the ICS. And, let’s assume that no materially misleading statements were made. That leaves the third requirement—the reasonable compensation limit. The reasonableness of compensation for services is determined by looking at the marketplace pricing for a particular set of services. But not all compensation in the marketplace is reasonable (for example, there is one case where a judge decided that fees above the 75th percentile were unreasonable or, more accurately, that fees below that percentile were reasonable). This requirement is also in the exemption, which must be satisfied beginning at the latest on December 21 of this year, and I suspect that the significance of it being in the exemption is underappreciated. That is because, where a person claims the protection of an exemption, the burden of proof of compliance is on that person (e.g., it is on the financial institution and the investment professional). As a result, financial institutions should have market data to demonstrate that their compensation is reasonable for the services provided.

Now, let’s look at the future–after December 20–when the exemption’s conditions must be satisfied. And, let’s just look at a couple of the conditions. First, the financial institution must have policies in place to ensure that the Impartial Conduct Standards are satisfied and that the conflicts of interest of both the financial institution and the investment professional are “mitigated”. In this case, the conflict is the compensation that would be earned by the financial institution and the investment professional if the investor agrees to transfer the IRA to the financial institution. How will that be mitigated?  Second, since this particular recommendation is considered a “rollover” recommendation, the financial institution must document in writing why the recommendation is in the best interest of the retirement investor and must deliver a copy of that writing to the investor. The development of the process for documenting that rationale and for delivering it to the investor must be developed and in place by December 21. That will require a thoughtful approach.

In addition, each year the financial institution must conduct a retrospective review of its compliance with the conditions of the PTE and the report must be reviewed and signed by a senior executive of the financial institution.

Compliance with these new requirements will be hard enough for large and mid-sized broker-dealers and investment advisers, but it will likely be much more difficult for smaller investment advisory firms and broker-dealers whose in-house compliance and legal staffs are much thinner.

Moving to the second example-recommending a transfer from a commission-based arrangement to a fee-based account (in an IRA, plan or participant account), the requirements are much the same:

• Adherence to the Impartial Conduct Standards until December 20, 2021.
• Establishing the practices, policies and procedures by December 21 in order to be in full compliance with the conditions of the exemption by then.
• Developing written explanations about why that recommendation is in the best interest of the retirement investor and providing that explanation to the investor.
• Implementing a process to satisfy retrospective review requirement.

I am concerned that some mid to small market broker-dealers and investment advisers may not realize the magnitude of the changes that need to be made. It is possible to comply with the non-enforcement policy (the Impartial Conduct Standards) fairly easily (but still with some effort). However, it is not possible to satisfy the full set of conditions in the PTE by December 21 without significant changes. That will likely be a time consuming and demanding project.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.