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 ERISA retirement plans, participants (including rollover recommendations), 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 are fiduciaries for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

In the preamble to the PTE, the DOL described its expanded definition of fiduciary advice. The fiduciary regulations in ERISA and the Internal Revenue Code have two definitions of fiduciary advice. The first is the obvious—where the investment professional and financial institution have discretion over retirement accounts (ERISA or tax qualified plans, participant accounts in those plans, and IRAs). In effect, that is a one-part test—“discretion”. In addition, there is a 5-part test for non-discretionary fiduciary advice. The DOL did not amend the regulation to modify any of the “parts,” but instead reinterpreted some of the parts, and particularly the “regular basis” part, to significantly increase the number of investment professionals and financial institutions who are fiduciaries. This article is not about the expanded definition, but instead about a circumstance in which a fiduciary could have more responsibility than anticipated.

In the preamble, the DOL discussed whether there is a duty to monitor investments that are made because of fiduciary recommendations to retirement investors. Here’s what it said: “…the Department expects that Financial Institutions and Investment Professionals will consider whether the investment can be prudently recommended without some mechanism or plan for ongoing monitoring.”

However, the preamble did not further define the types of investments that would require monitoring services. To the extent that the DOL gave any direction, it was:

In response to requests for guidance identifying specific products that will require monitoring, or what constitutes a product of unusual complexity and risk, the Department notes that Financial Institutions and Investment Professionals will need to make these decisions on a case-by-case basis. The Department expects that Financial Institutions and Investment Professionals have the expertise necessary to evaluate the need for monitoring based on all the facts and circumstances.

Obviously, that leaves financial institutions and investment professionals with the difficult task of determining whether a product is of unusual complexity and risk. Beyond that, it’s not clear if the expectation is about the sophistication of the particular retirement investor or about an “average” investor’s abilities.

Unfortunately, the DOL did not provide any other guidelines or examples to help determine if particular products are unusually complex or risky. But, helpfully, FINRA has. In Regulatory Notice 12-03, “Complex Products”, FINRA discussed the supervision of complex products and provided examples.

For example, the Notice said:

This Notice provides guidance to firms about the supervision of complex products, which may include a security or investment strategy with novel, complicated or intricate derivative-like features, such as structured notes, inverse or leveraged exchange-traded funds, hedge funds and securitized products, such as asset-backed securities. These features may make it difficult for a retail investor to understand the essential characteristics of the product and its risks.

The Notice identifies characteristics that may render a product “complex” for purposes of determining whether the product should be subject to heightened supervisory and compliance procedures and provides examples of heightened procedures that may be appropriate.

To avoid quoting extensively from RN 12-03, I will just list some of the products mentioned in the guidance:

• Equity-indexed annuities.
• Structured products.
• Leveraged and inverse exchange-traded funds.
• Principal protected notes.
• Reverse convertibles.
• Commodity futures-linked securities.
• Asset-backed securities.
• Unlisted REITs.
• Products that include an embedded derivative component.
• Investments tied to the performance of markets that may not be well understood by many investors.
• Products with principal protection that is conditional or partial.
• Product structures that can lead to performance that is significantly different from what an investor may expect.
• Products with complicated limits for formulas for the calculation of investor gains.

However, this list is not exhaustive. As explained in the Regulatory Notice:

Although this Notice provides guidance about the characteristics of many complex products, it does not define a “complex product” or provide an exhaustive list of features that might render a product “complex.” Moreover, some relatively simple products may also present significant risks to investors that warrant heightened scrutiny or supervision.

As a starting point, financial institutions should review FINRA Regulatory Notice 12-03 (and other guidance on complex and risky products, such as FINRA Regulatory Notice 22-08) and determine which products involve unusual complexity or risk and therefore fall into the “monitoring” category for purposes of PTE 2020-02. For the most part, this is likely to be an issue for recommendations to IRAs or so-called “solo” 401(k) plans. Then, financial institutions should decide what their approach will be for recommendations of products of unusual complexity or risk. If the firms and the investment professionals will continue to recommend those types of products for retirement accounts, they should develop procedures to identify those investments and ensure the delivery of the information about monitoring to the affected retirement investors.

Concluding Thoughts

Forewarned is forearmed. For retirement accounts, including IRAs, financial institutions and investment professionals need to consider whether recommended products are unusually complex or risky. If so, the choices are (1) to avoid recommending the products or (2) if such a product is recommended, to “clearly explain the need for monitoring to the investor when making the recommendation.”

The preamble to PTE 2020-02 has a number of requirements and statements that may come as a surprise to financial institutions, particularly about the best interest standard. While it is critical to understand the conditions of the PTE, it is also important to understand the preamble and its impact on fulfilling fiduciary/best interest requirements.

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.