The Department of Labor’s “Fiduciary Rule,” PTE 2020-02 (Part 15): Mitigation Strategies

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This series focuses on the DOL’s new fiduciary “rule”. This post is the 15th in a subseries discussing special or unique compliance issues related to the rule. This article looks at compliance with the rule’s mitigation requirements, with particular emphasis on broker-dealers and investment advisers.

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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 and Part 14, Two Compensation Requirements.

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 two posts discussed the duty to mitigate the conflicts of interest of investment professionals and financial institutions. This article discusses mitigation techniques described by the DOL in FAQ 17. The mitigation measures developed by broker-dealers for compliance with Reg BI’s Conflict Obligation will be helpful for complying with the DOL’s mitigation requirements for investment professionals. And, in some cases (as explained below), those measures may be helpful in satisfying the DOL’s mitigation requirements for the financial institutions subject to Reg BI (that is, for broker-dealers).

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 firm and individual conflicts.

As a reminder, the mitigation requirement in the PTE is:

Financial Institutions’ policies and procedures [must] 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.

The DOL explains its position on mitigation in FAQ 17:

Financial institutions should carefully assess their compensation practices for potential conflicts of interest and work to avoid structures that undermine investment professionals’ incentives to comply with the best interest standard. To be prudent and loyal, fiduciaries should design compensation structures that minimize the dangers associated with conflicts of interest, as opposed to designing structures that create or reinforce conflicts of interest that run contrary to the interests of the investor.

As that language suggests, the PTE 2020-02 mitigation requirement applies to conflicts generally. However, FAQ 17 focuses on the incentive effect of payout grids, suggesting that the DOL has a special interest in the design and effect of those grids. Q17 asks and answers (with my comments inserted):

Q17. Are there special considerations for financial institutions that use payout grids in implementing the exemption’s required policies and procedures?

If a financial institution wants to determine investment professional compensation through a payout grid, it should consider the following factors in developing its approach.

• Financial institutions should carefully review the amounts used as the basis for calculating investment professionals’ compensation to avoid simply passing along firm-level conflicts to their investment professionals. If, for example, investment professionals are paid a fixed percentage of the commission generated for the financial institution, this may transmit firm-level conflicts to the investment professional, who is effectively rewarded for preferentially recommending those investments that generate the greatest compensation for the firm. The overarching goal should be to avoid incentive structures that encourage investment professionals to make recommendations inconsistent with the Impartial Conduct Standards. Accordingly, firms should work to align the interests of their investment professionals and retirement investors, and to root out misaligned incentives to the extent possible.

Comment:  This is obviously problematic for broker-dealers, since most compensation arrangements with their investment professionals involve the sharing of commissions and similar payments. However, I don’t think I would interpret this as proposing to eliminate commissions, but rather would view this as expressing the DOL’s concerns about higher compensating investment alternatives. That could include investments within a defined category (for example, variable annuities), where some alternatives pay more than others. A broker-dealer could minimize the incentive effects by narrowing the range of commissions, or even by eliminating the incentive to select a particular higher-compensating investment (e.g., an annuity or mutual fund) by leveling the compensation paid to its investment professionals so that all investments in a particular category (e.g., variable annuities or mutual funds) pay the same percentage to the investment professionals.

• Grids with one or several modest or gradual increases are less likely to create impermissible incentives than grids characterized by large increases. Firms should be very careful about structures that disproportionately increase compensation at specified thresholds. These structures can undermine the best interest standard and create incentives for investment professionals to make recommendations based on their own financial interest, rather than the retirement investor’s interest in sound advice.

Comment:  This is similar to the approach taken by the SEC in Reg BI (and, prior to that, by the DOL in the Obama-era Best Interest Contract Exemption). As a result, broker-dealers should have already taken steps that may comply with this approach. But, better safe than sorry, and broker-dealers should review their compensation grids to ensure that they have adequately reduced the increases in production, and the corresponding increases in compensation, between the levels on their grids. In addition, broker-dealers should review their supervision of recommended transactions as their investment professionals approach each higher compensating level of production. That would likely be expected by the DOL (and perhaps the SEC).

• As the investment professional reaches a threshold on the grid, any resulting increase in compensation rate should generally be prospective – the new rate should apply only to new investments made once the threshold is reached. If the consequence of reaching a threshold is not only a higher compensation rate for new transactions, but also retroactive application of an increased rate of pay for past investments, the grid is likely to create acute conflicts of interest. Retroactivity magnifies the investment professional’s conflict of interest with respect to investment recommendations and increases the incentive to make the sales necessary to cross the threshold regardless of the investor’s interest. The danger is particularly great when the sales necessary to cross the threshold would generate compensation for the investment professional that are disproportionate to the compensation the professional would normally receive for recommendations that are not at the threshold.

Comment:  I think it’s fairly obvious that the DOL is saying that a cascading increase in compensation for achieving higher production levels is a “red flag” and disfavored. That is, it will be scrutinized closely with an eye to whether it could cause an investment professional to make recommendations that are not in the best interest of retirement investors. This could be particularly sensitive with regard to rollover recommendations and recommendations to transfer IRAs to the firm.

• As discussed in Q16, financial institutions employing escalating grids should establish a system to monitor and supervise investment professional recommendations, both at or near compensation thresholds and at a greater distance. Financial institutions should ensure that the thresholds do not create undue sales incentives. Aggressive thresholds can create incentives to make investment recommendations that are contrary to the retirement investor’s interest.

Comment:  The fact that the DOL FAQs focused on the incentive effect of grids, together with this statement, is a message to broker-dealers that the DOL is concerned about these compensation arrangements and that broker-dealers should pay close attention to the design of their escalating compensation grids. That message can be summarized as:  narrower ranges, compensation increases in smaller increases for each range, and close supervision.

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

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.