Best Interest Standard of Care for Advisors #49

The Department of Labor’s “Fiduciary Rule,” PTE 2020-02 (Part 14): The Two Compensation Requirements: Reasonable Compensation and Mitigation

This series focused on the DOL’s new fiduciary “rule”. This post is the 14th in a subseries discussing special or unique compliance issues related to the rule. This article looks at the issues related to complying with the rule’s reasonable compensation and mitigation requirements, with particular emphasis on broker-dealers and investment advisers.

On February 16, 2021, the DOL’s prohibited transaction exemption (PTE) 2020-02 became effective. (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. They will also need to satisfy the best interest standard of care. The relief provided by the exemption is conditional, that is, the “conditions” in the exemption must be satisfied to obtain relief from the prohibited transaction rules in ERISA and the Internal Revenue Code. For the period from February 16 until December 20, a DOL and IRS non-enforcement policy based on the Impartial Conduct Standards will be available.

This article builds on my earlier posts: Part 11, Mitigation; Part 12, Reasonable Compensation; and Part 13, Two Compensation Requirements. Compensation and mitigation are connected in the sense that unreasonably high compensation would be difficult to mitigate.

On April 13, 2021, the DOL issued a set of Frequently Asked Questions (FAQs) about PTE 2020-02 and the expanded definition of fiduciary advice.  In FAQs 16 and 17, the DOL discussed mitigation of the incentive effect of conflicts of interest. My last post (Part 13) discussed the duty to mitigate the conflicts of interest of the investment professionals. This article covers the requirement to mitigate the conflicts of the financial institutions (e.g., the broker-dealer or RIA firm). The mitigation measures developed by broker-dealers for compliance with Reg BI’s Conflict Obligation for their investment professionals will be helpful for complying with the DOL’s mitigation requirements for investment professionals. And, in some cases (as explained below), those measures will be helpful in complying with the DOL’s mitigation requirements for the broker-dealers themselves. However, RIAs are in a different boat. The SEC has not imposed a mitigation requirement on investment advisers, either for the investment professionals or the firms. As a result, RIAs will need to develop mitigation processes, policies and procedures, and supervisory practices for both the firm and individual conflicts.

The rule’s requirement that financial institutions mitigate their conflicts is explained in FAQ 16:

Q16. The exemption requires financial institutions’ policies and procedures to mitigate conflicts of interest “to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole” would conclude that they do not create an incentive for a financial institution or investment professional to place their interests ahead of the interest of the retirement investor. What should financial institutions do to meet this standard of mitigation?

In response, the DOL provided the following answer about the conflicts of the financial institution:

Financial institution conflicts. Financial institutions’ policies and procedures also should address and mitigate financial institutions’ own conflicts of interest, including by establishing or enhancing the review process for determining which investment products may be recommended to retirement investors. This review process should include procedures for identifying and mitigating the financial institutions’ conflicts of interest associated with investment products or, alternatively, declining to recommend a product if the financial institution cannot effectively mitigate associated conflicts of interest sufficiently to promote compliance with the Impartial Conduct Standards.

To help with the development of compliant mitigation practices, financial institutions should consider dividing their conflicts into two categories:

  • Conflicts that also impact their investment professionals. For example, these might include rollover recommendations and commissioned sales. In those situations, a recommendation by an investment professional can result in increased compensation for both the financial institution and the investment professional. And, in most of those cases, the techniques developed for mitigating the incentive effect of the professional’s recommendation would also mitigate the conflict for the financial institution.
  • Conflicts that do not result in increased compensation for investment professionals. An example would be revenue sharing payments from insurance companies, mutual funds, custodians, and other service providers that are not shared with the investment professionals. Another example would be proprietary investments managed by the financial institution or an affiliate. In those cases, the financial institution would need to mitigate the incentive effect of the conflicts so that the recommendations made by their professionals are in the best interest of the plans, participants or IRA owners.

Fortunately, the DOL recognizes that mitigation can be achieved by a variety of techniques and the measures may vary depending on the nature of the particular recommendation and the associated conflict. Those measures could include the processes used to develop the recommendation, reducing any differentials in compensation, and supervision. However, as an admonition, the burden of proving compliance with the mitigation requirement is on the financial institution. As a result, financial institutions should carefully consider whether their mitigation techniques satisfy the standard in PTE 2020-02:

Financial Institutions’ policies and procedures mitigate Conflicts of Interest to the extent that a reasonable person reviewing the policies and procedures and incentive practices as a whole would conclude that they do not create an incentive for a Financial Institution or Investment Professional to place their interests ahead of the interest of the Retirement Investor.

 It is possible that this standard is more demanding that the mitigation requirements under the Conflicts Obligation in Reg BI, which leaves “mitigate” largely undefined:  Identify and mitigate any conflicts of interest associated with such recommendations that create an incentive for a natural person who is an associated person of a broker or dealer to place the interest of the broker, dealer, or such natural person ahead of the interest of the retail customer;….

 Before leaving this subject, I should point out one other difference. While Reg BI covers “retail customers” (which includes participants and IRA owners), the DOL’s PTE 2020-02 covers plans, participants and IRA owners. As a result, broker-dealers will need to augment their mitigation policies and procedures to include recommendations to ERISA-governed retirement plans. And, as explained earlier, RIAs will need to develop compliant policies and procedures that cover all three types of “retirement” clients:  retirement plans, participants and IRA owners.

 My next article will cover some of the mitigation techniques discussed by the DOL in the preamble to PTE 2020-02 and the FAQs.

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.