The Department of Labor’s Proposed Prohibited Transaction Exemption and its Impact on Recommendations to Plans, Participants and IRAs (Part 2)

On July 7, 2020, the DOL issued a proposed prohibited transaction exemption (PTE) that would allow conflicted recommendations resulting from nondiscretionary fiduciary investment advice. The proposal is titled “Improving Investment Advice for Workers & Retirees.” And, as my last post, #36 (Part 1), explained, the DOL said that it is re-interpreting part of the definition of fiduciary advice to include many more recommendations, and especially rollover recommendations.

As background, an exemption is an exception to the prohibited transaction rules, but the exception is only available if its conditions are satisfied . . . and there are conditions. This article explains the conditions in the proposed PTE.

If finalized, the exemption would permit conflicted fiduciary advice to ERISA retirement plans, participants and IRAs. Many, if not most, investment recommendations of broker-dealers involve conflicts of interest, e.g., commissions on securities trades, 12b-1 fees on mutual funds, and commissions on variable annuities. Some advice by investment advisers also involve conflicts of interest, e.g., recommendations that result in revenue sharing payments to the investment adviser or the firm. And some conflicts apply to both, for example, recommendations of rollovers to IRAs.

However, the prohibited transaction rules do not apply to all recommendations. Instead, they only apply to fiduciary recommendations, and fiduciary status is determined by the DOL’s 5-part functional test. In this context, “functional” means that, if the recommendations or advice satisfy the 5-part definition, then the firm and the financial professional are fiduciaries for their recommendations to plans, participants and/or IRA owners. In the past, many broker-dealers have taken the position that their recommendations were not fiduciary advice because their services did not satisfy the “regular basis” part of the test, that is, they reasoned that they did not make recommendations to the plan or participant on a regular basis. Presumably, broker-dealers also took the position that they did not satisfy the 5-part fiduciary test for recommendations to IRAs, but it’s not clear because there aren’t any reported cases in that context.

As Part 1 of this series explained, the DOL also made it much easier for broker-dealers to satisfy the 5-part test and therefore to be fiduciaries. That is especially true for rollover recommendations. This article assumes fiduciary status under the DOL’s new interpretation and discusses the conditions that must be satisfied to obtain the relief afforded by the PTE. (The DOL recently sent the final exemption to the Office of Management and Budget (OMB) for review, but we will not know what, if any, changes were made until it is released by the OMB and published in the Federal Register. I will write a follow up article at that time.)

Broadly stated, fiduciary advice that results in a financial conflict of interest is prohibited under the Internal Revenue Code (Code) and ERISA. But the DOL can grant exemptions, or exceptions, that allow the conflicted transaction if the conditions of the exemption are satisfied. Here is an overview of the conditions in the DOL’s proposed PTE for nondiscretionary investment advice:

• The broker-dealer and the investment professional must comply with the Impartial Conduct Standards:
  • The advice must be in the “best interest” of the plan, participant or IRA owner (called “retirement investor” in the guidance). “Best interest” is, in essence, a combination of the prudent man rule and duty of loyalty, and parallels the best interest standard in Reg BI.
  • The compensation received, directly or indirectly, by the broker-dealer and investment professional cannot exceed reasonable compensation for the services rendered, and the broker-dealer and investment professional must seek to obtain the best execution of the investment transaction.
  • The broker-dealer and investment professional cannot make any materially misleading statements.
• The broker-dealer must make specified disclosures to the Retirement Investor, including:
  • A written acknowledgement that the broker-dealer and investment professional are fiduciaries under ERISA and the Code.
  • A written description of the services to be provided.
• The broker-dealer must have policies and procedures that:
  • Are prudently designed to ensure compliance with the Impartial Conduct Standards.
  • Mitigate conflicts of interest (g., due to form of compensation) of the investment professional.
  • Require documentation of certain specified transactions (g., rollover recommendations).
• The broker-dealer must conduct a retroactive review at least annually that:
  • Is designed help detect and prevent violations of the Impartial Conduct Standards and the policies and procedures governing compliance with the exemption.
  • Is documented in a written report to the firm’s CEO and CCO.
  • The firm’s CEO certifies the report.

Thoughts about the Exemption and Conditions

After the proposed exemption was issued, the DOL received a number of negative comments from the financial services sector, and particularly from broker-dealers and insurance companies. Because of those complaints, the DOL held virtual hearings on the proposal. (Two of the most common complaints were about (i) the requirement that the broker-dealer and investment professional acknowledge in writing that they are fiduciaries, and about (ii) the requirement that the CEO certify the annual retroactive review report.)

After the hearings, the DOL finalized the exemption and sent it to the OMB for review. But the final exemption won’t be released to the public until approved by the OMB. As a result, as of December 7, 2020 we don’t know how the proposal was changed after the DOL reviewed the comments and held the hearings. Once the OMB approves the final exemption, and it is published, I will follow up with an article that describes the changes. At this time, though, it appears that the exemption has been finalized too late to prevent the new Biden administration from delaying its application and possibly revising or even withdrawing the rule.

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.