The DOL “Fiduciary Rule,” FAQ 11: The Impartial Conduct Standards

This series focuses on the DOL’s new fiduciary “rule”, which was effective on February 16. This, and the next several, articles look at the Frequently Asked Questions (FAQs) issued by the DOL to explain the fiduciary definition and the exemption for conflicts of interest.

Background

The DOL’s prohibited transaction exemption (PTE) 2020-02 (Improving Investment Advice for Workers & Retirees) allows investment advisers, broker-dealers, banks, and insurance companies (“financial institutions”), and their representatives (“investment professionals”), to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to retirement plans, participants and IRA owners (“retirement investors”). In addition, in the preamble to the PTE the DOL announced an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals will be fiduciaries for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

In April, the DOL issued FAQs that explain the fiduciary interpretation and the conditions of the exemption.

This article discusses FAQ 11—a DOL question and answer about the Impartial Conduct Standards. The Impartial Conduct Standards must be satisfied between February 16 and December 20 to obtain the relief afforded by the DOL’s non-enforcement policy. After December 20, the Impartial Conduct Standards must still be satisfied…as one of the conditions in PTE 2020-02.

Here’s what the DOL said in FAQ 11:

Q11. What are the Impartial Conduct Standards?

The Impartial Conduct Standards are consumer protection standards that ensure that financial institutions and investment professionals adhere to fiduciary norms and basic standards of fair dealing. The standards specifically require financial institutions and investment professionals to:

• Give advice that is in the “best interest” of the retirement investor. This best interest standard has two chief components: prudence and loyalty;
• Under the prudence standard, the advice must meet a professional standard of care as specified in the text of the exemption;
• Under the loyalty standard, advice providers may not place their own interests ahead of the interests of the retirement investor, or subordinate the retirement investor’s interests to their own;
• Charge no more than reasonable compensation and comply with federal securities laws regarding “best execution”; and
• Make no misleading statements about investment transactions and other relevant matters.

This article looks at the best interest and reasonable compensation requirements.

First, with regard to the requirement that financial institutions (e.g., broker-dealers and registered investment advisers) receive no more than reasonable compensation, the determination of “reasonableness” is based on the services provided and the charges for those services in an open and competitive market place. Where the compensation and charges are transparent and common, the determination of reasonableness is not that difficult. Even there, though, financial institutions may want to consider benchmarking industry data to have evidence of the reasonableness of their compensation for each type of business (e.g., annuities, mutual funds, brokerage transactions). Since this requirement is a condition of an exemption (and an exemption is, in effect, an exception to a rule), the burden of proof shifts to the person claiming the protection of the exemption or, in other words, the burden of proof of reasonableness is on the broker-dealer or registered investment adviser.

Where the compensation to the financial institution and the investment professional is not fully transparent to a retirement investor, the determination of reasonableness may be more difficult. Since the PTE includes compensation paid to the financial institution, as well as to the investment professional, payments such as revenue sharing from mutual funds and insurance companies (which may not be fully transparent to a retirement investor) are included in the determination of reasonable compensation. Even less transparent may be payments (including commissions) from private equity funds, hedge funds, and similar investments. Since the prohibited transaction rules apply to recommendations to plans, participants and IRA owners, the reasonable compensation limitation also applies to those three categories of investors, that is, to “retirement investors”.

While most financial institutions have been hard at work to develop practices and policies to comply with the rollover requirements, the impact of the new DOL rules on IRAs has not received the same attention–at least in my experience.

Turning to the best interest standard, the PTE defines “best interest” as follows:

Advice is in a Retirement Investor’s ‘‘Best Interest’’ if such advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, and does not place the financial or other interests of the Investment Professional, Financial Institution or any Affiliate, Related Entity, or other party ahead of the interests of the Retirement Investor, or subordinate the Retirement Investor’s interests to their own. (Emphasis added.)

The bolded words are a verbatim repeat of ERISA’s prudent man rule, and can reasonably be viewed as incorporating that standard into the best interest standard in the PTE. In that regard, the words “care, skill, prudence, and diligence” have been interpreted to require that fiduciaries engage in prudent processes. In that regard, a prudent process requires that a fiduciary investment professional and financial institution collect the “relevant” information and evaluate that information in the best interest of the retirement investor. The words “familiar with such matters” are sometimes labelled the “prudent expert” rule, although the standard is not that demanding. Instead, it means that the process and the recommendation will be measured by what a hypothetical person—who is knowledgeable about the retirement investor’s profile and the available options—would have done. And, as that suggests, the “relevant factors” are those that the hypothetical “prudent person” who is “familiar with such matters” would have considered to be relevant, or material, to making a particular recommendation to the particular retirement investor.

The bottom line is that investment professionals and financial institutions are best positioned to show compliance with the best interest standard if there is a process that collects and appropriately evaluates the information relevant to the particular recommendation. And, while documentation of that process is not generally requires (with the exception of rollover recommendations), it would be a good risk mitigation approach to preserve the relevant information that was reviewed and that was the basis for the recommendation.

Concluding Thoughts

The Impartial Conduct Standards—a holdover from the Obama-era fiduciary rule—are a critical component of compliance with the DOL’s new interpretation of fiduciary advice and any prohibited transactions that result from those recommendations. While “reasonable compensation” is a requirement that needs some attention, most compensation practices of broker-dealers and registered investment advisers will already satisfy that standard. The “risky” compensation will be those payments that are higher than the customary range of costs and compensation for particular services or investments, with greater potential risk for compensation associated with complex and nontransparent investments.

Another component of the Impartial Conduct Standards—the best interest standard—is best understood as a process requirement with a focus on the information needed to make a prudent decision and the duty to put the retirement investor’s interests ahead of the interests of the financial institution and the investment professional. While documentation of that process is not generally required, financial institutions should consider maintaining documentation for risk management purposes (particularly for recommendations of complex and/or high risk investments).

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.