The Department of Labor’s “Fiduciary Rule,” PTE 2020-02 (Part 16): Mitigation Strategies

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This series focuses on the DOL’s new fiduciary “rule”. This post is the 16th in a subseries discussing special 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; Part 13 and Part 14, Two Compensation Requirements, and Part 15, Mitigation Strategies.

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.

My last post discussed mitigation strategies for compensation grids and the related discussion in the 2020-02 FAQs issued by the DOL. This article is about the mitigation techniques discussed in the preamble to the PTE, where the DOL said:

In developing compliance structures, the Department expects that Financial Institutions will also look to conflict mitigation strategies identified by the Financial Institutions’ other regulators. For illustrative purposes only, the following are non-exhaustive examples of practices identified as options by the SEC that could be implemented by Financial Institutions in compensating Investment Professionals:

(1) Avoiding compensation thresholds that disproportionately increase compensation through incremental increases in sales;

Comment:  In my last post I discussed the DOL FAQ on compensation grids. It provided the DOL’s view of the steps that could be taken to reduce any inappropriate incentive created by increased compensation due to reaching production levels in a grid.

(2) minimizing compensation incentives for employees to favor one type of account over another; or to favor one type of product over another, proprietary or preferred provider products, or comparable products sold on a principal basis, for example, by establishing differential compensation based on neutral factors;

Comment:  This is déjà vu with the Obama-era Best Interest Contract Exemption, where a “neutral factors” approach was used to justify differing compensation levels among different categories of investments. Unfortunately, it was difficult to calculate the differences in effort, sophistication, etc., in order to justify differing compensation among different products and types of investments. As a result, I doubt that many financial institutions will rely solely on neutral factors to justify compensation differentials. However, the broad concept is workable in the sense that different compensation levels for different types of investments could be justified by neutral factors, e.g., the effort and expertise of the financial institution and the investment professional, when those factors are coupled with good processes for selecting investments and account types, as well as appropriate supervision. In other words, I doubt that neutral factors alone will be used much, if at all, but the concept can be used in combination with other practices. Obviously, though, the greater the compensation differentials, the more pressure it puts on the mitigation strategies.

(3) eliminating compensation incentives within comparable product lines by, for example, capping the credit that an associated person may receive across mutual funds or other comparable products across providers;

Comment: By eliminating compensation differences for a particular product line (e.g., mutual funds), the incentive effect of recommending one fund over another is eliminated. As a result, the theory is that the investment professional’s only interest will be to select the investment or strategy that is in the best interest of the retirement investor. However, it may be enough to limit any differences to relatively small ranges. For example, if the front-end loads of A share mutual funds range between 4% and 5%, there would be little incentive (except in cases of very large investment amounts) to prefer one fund over another to advance the financial interests of the investment professional. But, with the narrow range approach, there would still need to be appropriate supervision, especially when large dollar amounts were being invested.

(4) implementing supervisory procedures to monitor recommendations that are: Near compensation thresholds; near thresholds for firm recognition; involve higher compensating products, proprietary products, or transactions in a principal capacity; or, involve the rollover or transfer of assets from one type of account to another (such as recommendations to roll over or transfer assets in a Title I Plan account to an IRA) or from one product class to another;

Comment:  This is similar to the discussion in my last post concerning the DOL FAQ on mitigating the incentive effects of grids. With regard to rollover recommendations (and other recommendations where the financial institution and investment professional will earn nothing if the recommendation isn’t accepted by the retirement investor), the incentive can’t be mitigated through eliminating or reducing compensation differences. As a result, the incentive effect for those types of recommendations would probably need to be mitigated by well-defined, appropriate, and probably documented processes for making the recommendation, as well as closer supervision.

(5) adjusting compensation for associated persons who fail to adequately manage conflicts of interest; and

Comment:  The rationale behind this mitigation technique seems obvious. There need to be consequences for failure to follow a firm’s processes and policies. That is one way of managing the conflict issues going forward.

(6) limiting the types of retail customer to whom a product, transaction or strategy may be recommended.

Comment:  While the rationale for this is not clear, it may apply to more complex, less transparent, and more highly compensating investments, particularly for recommendations to retirement investors who lack the experience or knowledge to understand the investments.

Concluding thoughts:

Compliance with the mitigation requirements (for both the investment professionals and financial institutions) will be demanding. In most cases, the key will be the process for developing the recommendations to the retirement investor. A good process, properly supervised, will often, in and of itself, mitigate the incentive effect of any compensation differentials.

But, mitigation is a principles-based approach. It requires a balance of approaches, which taken together, would be viewed by a reasonable person as effectively dampening the incentive effect of compensation (and particularly transaction-based compensation) such that any recommendations are in the best interest of the investor (and not primarily in the interest of the investment professional). This requires risk-based analysis. It also suggests that the mitigation “solutions” be reviewed someone outside of the financial institution. The internal approach at a financial institution might be to continue business as usual. But, compliance with PTE 2020-02 requires changes to existing practices.

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.