Best Interest Standard of Care for Advisors #44

The Department of Labor’s Prohibited Transaction Exemption and Its Impact on Recommendations to Plans, Participants and IRAs (Part 9)


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.” It 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 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 and therefore will need the protections afforded by the exemption. In addition, they will need prudent, or best practice, processes to satisfy the fiduciary and best interest 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) until December 20 of this year, a DOL and IRS non-enforcement policy for prohibited transactions will be available in lieu of the exemption. That is, neither the IRS nor the DOL will enforce the rules against transactions with plans, participants or IRA owners that result from nondiscretionary fiduciary advice and that are prohibited in the Code or ERISA, so long as the Impartial Conduct Standards are satisfied. The Impartial Conduct Standards are: the best interest standard of care, a limit on compensation to reasonable amounts, and a prohibition of materially misleading statements. Note, though, that this only binds the DOL and IRS. That is, the non-enforcement policy does not limit private claims that otherwise exist in the law (e.g., ERISA).

This article builds on my earlier posts about the DOL’s rule, Parts 1-8.

This article is about the fiduciary duty to prudently recommend investments to plans, participants and IRA owners. Of course, ERISA’s fiduciary, and the DOL’s best interest, standards only apply where the investment professional and financial institution are fiduciaries under the 5-part test in a 1975 regulation that defined fiduciary advice. However, in the preamble to the PTE the DOL significantly expanded the definition of some prongs of the 5-part test, meaning that investment professionals and financial institutions will be more likely to be fiduciaries for the advice they give to “retirement investors”.

With that background, the DOL also said that it had an expansive view of when a fiduciary could be obligated to provide monitoring services, regardless of whether the fiduciary was a broker-dealer or an investment adviser.

In the preamble to the proposed exemption, the DOL said that:

 “Financial Institutions should carefully consider whether certain investments can be prudently recommended to the individual Retirement Investor in the first place without ongoing monitoring of the investment. Investments that possess unusual complexity and risk, for example, may require ongoing monitoring to protect the investor’s interests.”

 Then, in the preamble for the final exemption, the DOL said:

“The Department did not require all Financial Institutions and Investment Professionals to offer monitoring because the exemption takes the approach of preserving the availability of a wide variety of investment advice arrangements and products. However, as part of making a best interest recommendation, 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.”

The DOL is saying, in effect, that it would be imprudent for a fiduciary to make an investment recommendation to a retirement investor that would reasonably require monitoring where the investment professional did not intend to provide monitoring.

A question is whether the ability of a retirement investor to self-monitor an investment is measured by a hypothetical “reasonable” retirement investor or the individual retirement investor who receives the recommendation. Here is what the DOL said in the preamble to the final exemption:

“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.” [Emphasis added.]

 While not entirely clear, this language could mean that the analysis must be done on an individualized basis, that is, is the particular retirement investor able to monitor the investment that is recommended?  Needless to say, if that is the standard it will be difficult to implement and supervise. In that case, some financial institutions may opt for a conservative answer, which could be to only recommend transparent and liquid investments to retirement investors (or at least to retirement investors who may not clearly be experienced or sophisticated). That is not required by the exemption, but it could be one outcome of the DOL’s position.

Concluding Thoughts

 This DOL-imposed requirement may not create problems for investment advisers, since they often provide monitoring services. However, that is not the case for broker-dealers, who usually don’t agree to monitor. The difficulty is compounded by the lack of a clear standard for when an investment recommended to a retirement investor could need monitoring (and therefore an investment could not be prudently be recommended without monitoring services). The DOL refers to “investments that possess unusual complexity and risk” and suggests that the standard is whether the retirement investor has the ability to monitor the investment without help. However, that may be a difficult standard to implement.

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

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