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 (all of whom are referred to as “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.

For example, a rollover recommendation will ordinarily be nondiscretionary fiduciary advice and result in a financial conflict of interest (i.e., the compensation earned from the rollover IRA) that is a prohibited transaction under both ERISA and the Internal Revenue Code. But, since the recommendation is nondiscretionary, PTE 2020-02 provides relief, but only if all of its conditions are met.

Those conditions are:

• Adherence to the Impartial Conduct Standards.
• Providing the four required disclosures.
• Adopting and implementing the required policies and procedures.
• Conducting an annual retrospective review and recording the findings in a written report.

The first three of those conditions required compliance on February 1, 2022, with the exception of the requirement to provide retirement investors with the specific reasons why a rollover recommendation is in their best interest. That requirement was effective on July 1, 2022.

But the fourth condition—the annual retrospective review—can’t be satisfied until next year, since it involves a review of the covered recommendations in 2022. Before discussing the requirement of the annual review, I should point out that it is a condition of the exemption. That means that, if the review isn’t performed and the report certified as required, the financial institution (e.g., broker-dealer or RIA firm) didn’t satisfy the requirements of the PTE and the relief provided by the PTE isn’t available. As a result, all the covered recommendations for the year, including any rollover recommendations, would be prohibited transactions, with disastrous consequences…possible damages, loss of compensation, interest accruals on the compensation until restored, penalties and excise taxes. The preamble to PTE 2020-02 explains:

In response to commenters who asked the Department to specify the consequences of a violation discovered in the retrospective review, and other commenters who asked for the ability to correct compliance issues uncovered during the review, the Department has included a self-correction feature in the final exemption, as described below. If self-correction is not available or a Financial Institution decides not to self-correct, then the Financial Institution remains liable for a prohibited transaction associated with the transaction for which there was a failure.

Now, let’s look at the requirement in the PTE:

Retrospective Review.

1. The Financial Institution conducts a retrospective review, at least annually, that is reasonably designed to assist the Financial Institution in detecting and preventing violations of, and achieving compliance with, the Impartial Conduct Standards and the policies and procedures governing compliance with the exemption.
2. The methodology and results of the retrospective review are reduced to a written report that is provided to a Senior Executive Officer.
3. A Senior Executive Officer of the Financial Institution certifies, annually, that:
   1. The officer has reviewed the report of the retrospective review;
   2. The Financial Institution has in place policies and procedures prudently designed to achieve compliance with the conditions of this exemption; and
   3. The Financial Institution has in place a prudent process to modify such policies and procedures as business, regulatory, and legislative changes and events dictate, and to test the effectiveness of such policies and procedures on a periodic basis, the timing and extent of which is reasonably designed to ensure continuing compliance with the conditions of this exemption.
4. The review, report and certification are completed no later than six months following the end of the period covered by the review.
5. The Financial Institution retains the report, certification, and supporting data for a period of six years and makes the report, certification, and supporting data available to the Department, within 10 business days of request, to the extent permitted by law including 12 U.S.C. 484

The requirements are fairly straightforward. A review must be done of the covered recommendations that were made in the preceding year and the review must be reduced to writing in a report, which must be certified by a senior executive officer of the firm within 6 months after the end of the year under review.

If the senior executive officer doesn’t have the expertise to properly certify the report, the officer must seek competent help. The preamble says:  If the officer does not have the experience or expertise to determine whether to make the certification, he or she would be expected to consult with a knowledgeable compliance professional to be able to do so.

There are unanswered questions, though. How complete must the sampling of recommendations be?  The provision says that the review must be “reasonably designed to assist the Financial Institution in detecting and preventing violations of, and achieving compliance with, the Impartial Conduct Standards and the policies and procedures governing compliance with the exemption.” While the DOL doesn’t say so, it seems that the scope of the review is a statistical issue in the sense that the review must be “reasonably designed” to accomplish its purposes.

The preamble also addresses the review and does provide some guidance. Here’s what it says: The retrospective review is based on FINRA rules governing how broker-dealers supervise associated persons, adapted to focus on the conditions of the exemption.

That statement is footnoted with the following: See FINRA rules 3110, 3120, and 3130.

As a result, firms that are familiar with those FINRA rules should have a good idea of what is expected. Others may want to refer to those rules.

Note, though, that the preamble also says: To maintain this principles-based approach, the Department did not mandate specific detailed components of the retrospective review. Financial Institutions will be free to design the review process in the context of their own business models and the particular conflicts of interest they face.

The preamble adds, referring to the review: … the Department clarifies that an appropriate retrospective review would be aimed at detecting non-compliance across a wide range of transactions types and sizes, large and small, identifying deficiencies in the policies and procedures, and rectifying those deficiencies…it is an important and necessary component of any prudent review process, and should be performed in a manner designed to identify potential violations, problems, and deficiencies that need to be addressed.

In the process of performing the review, firms may discover covered recommendations where one or more of the PTE’s conditions were not satisfied. The PTE anticipated that and has a self-correction provision which, if followed, allows the firm to avoid the  prohibited transaction consequences of a failure. See Best Interest #93. Note that discovered failures and self-corrections must be included in the report. The self-correction provision in the PTE has 4 requirements, and the fourth is:  The Financial Institution notifies the person(s) responsible for conducting the retrospective review during the applicable review cycle and the violation and correction is specifically set forth in the written report of the retrospective review required under subsection II(d)(2).

Finally, the records reviewed for the retrospective review must be retained for six years. The PTE provides:

The Financial Institution retains the report, certification, and supporting data for a period of six years and makes the report, certification, and supporting data available to the Department, within 10 business days of request, to the extent permitted by law including 12 U.S.C. 484.

While not entirely clear, it appears that the “supporting data” would be the documentation that the PTE’s conditions were satisfied. That would include, for example, data that, for rollover recommendations, demonstrates that the required plan and/or IRA information was obtained and reviewed, that the retirement investor was given the specific reason why a rollover recommendation was in the investor’s best interest, that disclosures were provided, and that the other conditions were satisfied. Unfortunately, the preamble does not provide greater insight into the DOL’s expectations. However, it seems difficult to imagine how the annual review of covered transactions could be done without reviewing the recommendations at that level of detail.

Concluding Thoughts

Even though the retrospective review won’t begin until next year (2023), the preparations should begin now. Firms need to be able to easily identify all of the covered recommendations in order to conduct the review. As a result, firms should be well advised to have an intake process that identifies covered recommendations and transactions, so that they can be retrieved for purposes of the review.

In addition, firms need to have a documentation retention policy that allows them to retrospectively review the information considered for purposes of making those recommendations.

The retrospective review will be difficult without the ability to identify covered transactions and without the ability to retrieve the information needed to determine if a recommendation was in the best interest of a retirement investor.

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.