The DOL “Fiduciary Rule,” FAQ 12: PTE 2020-02 and Conflicted Compensation

This series focuses on the DOL’s new fiduciary “rule”, which was effective on February 16. This, and the next several, articles look at the Frequently Asked Questions (FAQs) issued by the DOL to explain the fiduciary definition and the exemption for conflicts of interest.

Background

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, 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 for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

In April, the DOL issued FAQs that explain the fiduciary interpretation and the conditions of the exemption.

This article discusses FAQ 12—a DOL question and answer about the receipt of compensation resulting from recommendations to retirement investors.

The DOL’s question and answer in FAQ 12 were:

Q12. Does the best interest standard prevent financial institutions and investment professionals from receiving payment for their advice?

No. The best interest standard allows investment professionals and financial institutions to provide investment advice despite having a financial interest in the transaction, such as receiving payment, so long as they do not place their own interests ahead of the interests of the retirement investor or subordinate the retirement investor’s interests to their own. Under this standard, the advice must be based on the interests of the customer, rather than the competing financial interest of the investment professional or financial institution. This means, for example, that in choosing between two investments equally available to the investor, it is not permissible for the investment professional to advise investing in the one that is worse for the retirement investor because it is better for the investment professional’s or the financial institution’s bottom line. The requirements of PTE 2020-02 are intended to work with a wide variety of payment structures.

The DOL’s language can be read to mean that, if an investment professional recommends a more expensive investment option that pays more to the professional (and the financial institution), the operating presumption will be—at least from the DOL’s perspective—that the recommendation was imprudent. I say “presumption” rather than “conclusion” because, if an investment professional and financial institution can show that the recommended investment was superior to the alternative, the cost differential could be offset by the quality or other features of the recommended alternative. (I use the word “presumption” loosely; I don’t believe that there will be an actual enforcement presumption by the DOL; instead, my comment is meant to point out that an expensive investment would likely invite inquiry by a DOL investigator, especially if it paid higher compensation and that was part of the reason that the investment was more expensive.)

While the example in Q 12 specifically refers to cost and compensation, the point is that the conditions of PTE 2020-02 must be satisfied. Between February 16, 2021 and December 20, 2021, a DOL policy permits financial institutions to avoid enforcement of the full conditions of the PTE, if a financial institution satisfied the Impartial Conduct Standards, which include a best interest standard of care. Beginning December 21, all of the conditions of the PTE must be satisfied to avoid prohibited transactions and to retain any compensation earned as a result of the covered recommendations to retirement investors. And, to no one’s surprise, the PTE’s conditions include satisfaction of a best interest standard of care. In other words, a covered recommendation must be in the best interest of the retirement investor, both as a standard of care and as standard of loyalty.

To be clear, this is not the SEC’s best interest standard for broker-dealers in Reg BI, or even the fiduciary standard for investment advisers. Instead, it is ERISA’s prudent man rule and duty of loyalty. It already has a history of litigation and enumerable court decisions which serve as precedent. As a result, and while the other conditions of the exemption are important, particular attention should be paid to the PTE’s best interest process for developing recommendations to retirement investors. That process should reflect the care, skill, diligence and prudence of a knowledgeable person who is acting with a duty of loyalty to, and in the best interest of, the retirement investor.

Concluding Thoughts

December 21 is just around the corner. Financial institutions, such as broker-dealers and investment advisers, should be developing the required policies, procedures and processes for compliance. In doing that work, attention should be given to how compliance will be reviewed and reported for purposes of the retrospective annual review and report that is required by the PTE. In particular, what will the best interest processes be for the different types of recommendations that the investment professionals will make to retirement investors. And what documentation will be needed for the firm—the financial institution—to review for purposes of preparing the retrospective report (which must be certified by a senior executive of the firm).

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.