The Department of Labor’s “Fiduciary Rule,” PTE 2020-02: An Overview

This article is an overview of the requirements of PTE 2020-02. It discusses the expanded fiduciary definition, the conditions in the PTE, and the DOL’s non-enforcement policy in effect until December 20, 2021.

The DOL’s prohibited transaction exemption (PTE) 2020-02 (Improving Investment Advice for Workers & Retirees) 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 addition, the DOL announced, in the preamble to the PTE, an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals will be fiduciaries for their recommendations to retirement investors and therefore will need the protections afforded by the exemption. The relief provided by the exemption is conditional, that is, the “conditions” in the exemption must be satisfied in order 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.

In April, the DOL issued FAQs that explain its reasons for issuing the guidance. The FAQs also go into detail about the fiduciary definition and the conditions of the exemption.

Memorandum to Chief Compliance Officer

The Chief Compliance Officer of a dual registrant broker-dealer and investment adviser recently asked for a memorandum summarizing the DOL guidance and the need to start working on compliance with the complex and burdensome conditions in the PTE. The purpose was to provide a short summary for the executives at the firm. My response follows (and this redacted version is included here with the permission of the client).

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On February 16, 2021, a new DOL fiduciary “rule” became effective. The rule is a combination of a new and expansive definition of fiduciary advice (and status) and an exemption from the prohibitions of ERISA and the Internal Revenue Code for certain conflicts of interest arising from nondiscretionary fiduciary recommendations. This memorandum discusses the new guidance, the requirements already in effect, and the additional requirements that become effective later this year (on December 21, 2021).

Scope of the new Rule

The DOL’s guidance applies to advice to ERISA retirement plans and participants, and to IRA owners (which are referred to as “retirement investors”) by financial institutions and investment professionals. “Financial institutions” is used to mean registered investment advisers, broker-dealers, banks and trust companies, and insurance companies. “Investment professionals” refers to the representatives and agents of those financial institutions.

In the preamble to the exemption, the DOL announced an expanded definition of when financial institutions and investment professionals become ERISA and Code fiduciaries. Specifically the DOL redefined parts of the 5-part functional test for fiduciary status. For example, and as it relates to rollover recommendations, in an explanatory set of FAQs issued in April, the DOL asked and answered:

Q7. When is advice to roll over assets from an employee benefit plan to an IRA considered to be a on a “regular basis”?

A single, discrete instance of advice to roll over assets from an employee benefit plan to an IRA would not meet the regular basis prong of the 1975 test. However, advice to roll over plan assets can also occur as part of an ongoing relationship or as the beginning of an intended future ongoing relationship that an individual has with an investment advice provider. When the investment advice provider has been giving advice to the individual about investing in, purchasing, or selling securities or other financial instruments through tax-advantaged retirement vehicles subject to ERISA or the Code, the advice to roll assets out of the employee benefit plan is part of an ongoing advice relationship that satisfies the regular basis prong. Similarly, when the investment advice provider has not previously provided advice but expects to regularly make investment recommendations regarding the IRA as part of an ongoing relationship, the advice to roll assets out of an employee benefit plan into an IRA would be the start of an advice relationship that satisfies the regular basis requirement. The 1975 test extends to the entire advice relationship and does not exclude the first instance of advice, such as a recommendation to roll plan assets to an IRA, in an ongoing advice relationship.

In other words, if an investment adviser or broker-dealer recommends a rollover to a participant, and the contemplation is that the rollover will be to an IRA with the advisory firm or the broker-dealer…and that investment recommendations will be made periodically to the IRA owner, the “regular basis” part of the 5-part test of fiduciary status is satisfied. (The significance of satisfying the regular basis requirement is that the other 4 parts of the test are often also satisfied in the ordinary course of events, meaning that the broker-dealer or the advisory firm would be a fiduciary.) The 5-part test is a functional test and cannot be avoided by contract alone.

Also, the DOL interprets a “rollover” very broadly to include, e.g., a rollover from a plan to an IRA, from an IRA to a plan, from an IRA to an IRA, or a change of account types for a plan or an IRA (e.g., from commission-based to fee-based).

While this example is of a rollover recommendation, other advice to plans, participants and IRA owners is similarly impacted.

Once a firm (and its representative) become a fiduciary under these tests, the next step is to determine whether the fiduciary recommendation results in a conflict of interest (or, in the language of ERISA and the Code, a “prohibited transaction”). For example, a rollover recommendation, if accepted by the participant, will usually result in a prohibited transaction because of the compensation that will be earned from the IRA.

(Other common conflicts that are prohibited are any third party payments (e.g., revenue sharing, insurance commissions, solicitor fees), any transaction based payments (e.g., securities commissions, 12b-1 fees), and proprietary investments.)

As a result, investment advisory firms and broker-dealers will need the protection of the new Prohibited Transaction Exemption (PTE) 2020-02. However the exemption has a number of conditions that must be satisfied. The remainder of this memorandum discusses the DOL’s temporary non-enforcement policy in effect until December 20 and the full conditions of the PTE which must be satisfied beginning December 21.

DOL Non-enforcement Policy

While the new rule was fully effective on February 16, the DOL issued (with concurrence by the IRS) a non-enforcement policy. That is, the DOL (and IRS) will not enforce the full conditions of the PTE until December 21 so long as the financial institution and investment professional satisfy the Impartial Conduct Standards. Here is how the DOL explained those Standards in their April FAQs:

Q11. What are the Impartial Conduct Standards?

The Impartial Conduct Standards are consumer protection standards that ensure that financial institutions and investment professionals adhere to fiduciary norms and basic standards of fair dealing. The standards specifically require financial institutions and investment professionals to:

• • Give advice that is in the “best interest” of the retirement investor. This best interest standard has two chief components: prudence and loyalty;
    • Under the prudence standard, the advice must meet a professional standard of care as specified in the text of the exemption;
    • Under the loyalty standard, advice providers may not place their own interests ahead of the interests of the retirement investor, or   subordinate the retirement investor’s interests to their own;

• Charge no more than reasonable compensation and comply with federal securities laws regarding “best execution”; and
• Make no misleading statements about investment transactions and other relevant matters.

Of the three Standards, the best interest standard is the more difficult to satisfy. Essentially it is a combination of ERISA’s prudent man rule and duty of loyalty. That standard requires that the financial institution and investment professional engage in a process that considers the appropriate information and reaches an informed decision that is in the best interest of the retirement investor. For example, in a rollover context, the financial institution would need to gather and consider: (1) information about the investments, costs and services in the plan; (2) information about the investments, services and costs in the available IRA; (3) information about the needs and circumstances of the participant. The best interest standard then requires that the information be evaluated at the level of a person knowledgeable about the relevant issues (e.g., plans, IRAs, retirement investing, etc.) and the resulting recommendation would need to be in the best interest of the retirement investor.

The Full Conditions of PTE 2020-02

The non-enforcement policy expires on December 20, and thereafter the full conditions of the exemption must be satisfied. Here is a list of those conditions:

• The Impartial Conduct Standards continue to apply.
• A written acknowledgement that the financial institution and investment professional are fiduciaries.
• A written description of the services to be provided and the material conflicts of interest of the financial institution and investment professional. (Presumably, e.g., a rollover recommendation results in a material conflict.)
• For rollover recommendations, the retirement investor must be given documentation of the specific reasons why the rollover recommendation is in the best interest of the retirement investor. (Keep in mind that “rollover” is broadly defined.)
• The financial institution must have written policies and procedures to ensure compliance with the Impartial Conduct Standards.
• The Financial Institution’s policies and procedures must mitigate conflicts so that they do not create an incentive for the firm or its investment professionals “to place their interests ahead of the interest of the Retirement Investor”.
• Each year the Financial Institution must do a retrospective review of compliance with the requirements of the PTE. The results must be documented in a report that is reviewed and signed by a senior executive officer of the firm.

Recommendations

These requirements are new, complex and burdensome. It will take a considerable amount of time and thought to make the decisions that are needed to develop compliant processes. That will be followed by development of the required written materials (e.g., the policies and procedures) and training for supervisory personnel and investment professionals. There is only a limited amount of time to do that.

Note: This is a summary of lengthy and complicated documents. As a result, some significant requirements and definitions have been omitted. This is intended to provide an explanation for general discussions of the work to be done and the timing. For specific compliance efforts, though, more detailed information will be needed.

 Concluding Thoughts

Time is running out…the processes and documentation must be in place by December 21, and the training should occur before that. While some broker-dealers may be thinking that their Reg BI compliance efforts will cover these new requirements. Unfortunately, that is not the case. For example, the PTE’s mitigation requirements appear to be more demanding than the SEC’s. And the PTE’s mitigation rules apply at the firm level, while the SEC’s do not.

Some RIAs may believe that they are conflict free, but that is almost never the case. For example, a recommendation to rollover from a plan to an IRA is a conflict of interest that is covered by the PTE, as well as a recommendation to transfer an IRA from another firm to an account with the RIA. If an RIA’s advisers recommend either of those two covered recommendations, the full conditions of the PTE will need to be satisfied to avoid the prohibited transaction consequences. Some of the PTE requirements are new to RIAs, for example, the mitigation requirements, the written statement of why a rollover is in the best interest of a participant, and the annual retrospective review and report requirement.

Now is the time to be working on compliance processes and documentation.

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.