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

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 ERISA retirement plans, participants (including rollover recommendations), 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.

Specifically, one of the conditions for relief under PTE 2020-02 is mitigation of conflicts of interest. The PTE describes that requirement as:

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 appears that the PTE’s definition of mitigation is more demanding than the SEC Reg BI definition:

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;…

For example, Reg BI requires mitigation of conflicts, but does not provide any guidance about the degree of mitigation that will be required. However, PTE 2020-02 appears to require that the mitigation reasonably eliminates the incentive for the firm or the retirement professional to place their interests ahead of the retirement investor. If literally applied, it would be hard to satisfy that standard, since transaction-based compensation acts as an incentive. As a result, it remains to be seen if the PTE will be enforced in a manner that requires more stringent mitigation practices than Reg BI does.

Discussion

In April 2021, the DOL issued a set of Frequently Asked Questions (FAQs) to explain the requirements of PTE 2020-02. This article continues the discussion of the questions and answers by looking at FAQ 16, mitigation of conflicts.

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?

Financial institutions intending to rely on PTE 2020-02 must identify and carefully focus on the conflicts of interest associated with their business models and practices that create incentives for the financial institution or investment professional to place their interests ahead of the retirement investor’s interest. Financial institutions’ policies and procedures must be prudently designed to, among other things, protect retirement investors from recommendations to make excessive trades, to buy investment products, annuities, or riders that are not in the investor’s best interest, or to allocate excessive amounts to illiquid or risky investments. The policies and procedures should themselves be reviewed and updated to ensure they stay effective and up to date.

Comment: Both Reg BI and PTE 2020-02 contemplate periodic (e.g., annual) review of the firm’s conflicts of interest. If changes in products or services cause new conflicts, the expectation would be that the firm’s policies and procedures be updated appropriately.

However, there is a significant difference between the conflict mitigation requirements of Reg BI and the PTE. Reg BI only requires mitigation of the conflicts of the investment professionals. But PTE 2020-02 requires mitigation of the conflicts of both the firm and the investment professional. As a result, the conflicts policies should be updated to include the requirement in PTE 2020-02 that the conflicts of the firm also be mitigated.

The answer to FAQ 16 continues:

Under the exemption’s mitigation standard, it is important that financial institutions eliminate or mitigate incentives that are misaligned with the interests of their customers and that they adopt and implement effective oversight structures. In determining whether the exemption’s standard for policies and procedures is met, the Department examines the financial institution’s conflict mitigation and supervisory oversight as a whole. The conflict mitigation requirement in the policies and procedures condition is not limited to conflicts of investment professionals and extends to the financial institution’s own interests, including interests in proprietary products and limited menus of investment options that generate third party payments (e.g., revenue sharing arrangements). As the Department stated in the preamble of PTE 2020-02, financial institutions must comply with the standards of the exemption to obtain relief from the prohibited transaction rules. There is no safe harbor based solely on compliance with other regulators’ standards.

Comment: The conflicts that can be prohibited transactions, and therefor need the relief afforded by 2020-02, are those of the firm, its investment professionals and any affiliates. The conflicts that result from compensation to affiliates and related entities are covered by the PTE. That explains the reference to proprietary investments. In describing “covered transactions” the PTE says:  This exemption permits Financial Institutions and Investment Professionals, and their Affiliates and Related Entities, to engage in the following transactions….

As a result, the PTE’s conditions, including the mitigation requirement, should cover recommendations to retirement investors of products of affiliates and related entities.

As the bolded language points out, compliance with the requirements of other regulators (e.g., the SEC, FINRA, or state insurance departments) will not necessarily satisfy the PTE’s requirements, even when similar “labels” are used, e.g., best interest or mitigate. Instead, the DOL expects satisfaction with those standards as they are defined in the PTE.

Concluding Thoughts

Obviously, financial institutions, such as broker-dealers and RIAs, should identify their conflicts of interest, and then develop policies and procedures to mitigate those conflicts as they apply to retirement accounts (ERISA retirement plans, participants and IRA investors). Because of the DOL’s demanding definition of mitigation, financial institutions should review their current mitigation policies to determine if they meet that standard.

In addition, firms should ensure that they have identified all conflicts of interest at both the firm and investment professional levels, as well as at affiliates and related parties, and have mitigation policies for those conflicts.

Finally, firms should establish a process for periodically reviewing their conflicts to determine if their policies and procedures cover all of their conflicts or if new products or services have been added that create incentives that require new mitigation techniques.

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.