Best Interest Standard of Care for Advisors #76: Compliance with PTE 2020-02: Mitigation of Conflicts (Part 3)

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

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.

Key Takeaways

  • The DOL has issued FAQs that generally explain PTE 2020-02 and the expanded definition of fiduciary advice.
  • In FAQ 16, the DOL discusses the requirements to have policies and procedures to mitigate conflicts of interest. The mitigation requirement applies to conflicts both at the firm level and at the investment professional level.
  • The requirement is that the policies and procedures mitigate conflicts of interest “to the extent that a reasonable person reviewing the policies and procedures and incentives as a whole would conclude that they do not create an incentive for the firm or the investment professional to place their interests ahead of the interest of the retirement investor”.
  • Best Interest #74 (Part 1) discussed the general requirements under FAQ 16 to mitigate conflicts of interest of both the financial institution and the investment professional. Best Interest #75 (Part 2) looked at mitigation of conflicts of investment professional. This post discusses the mitigation of conflicts for the financial institutions, including broker-dealers, investment advisers, insurance companies and banks and trust companies.

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 are 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’s 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;…

Reg BI requires mitigation of conflicts, but does not provide any guidance about the degree of mitigation that is required. However, PTE 2020-02 seems to require that the mitigation reasonably eliminates the incentive for the firm and 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. In FAQ 16, the DOL asked and answered the following:

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?

Best Interest #74 quoted and discussed the general requirements in the first part of the answer to that question. In Best Interest #75, I discussed the DOL’s statements about the requirements that apply specifically to investment professionals. This post provides and discusses the DOL’s answer regarding the application of the mitigation requirement to financial institutions. In the part of FAQ 16, the DOL said:

Financial institution conflicts. Financial institutions’ policies and procedures also should address and mitigate financial institutions’ own conflicts of interest, including by establishing or enhancing the review process for determining which investment products may be recommended to retirement investors. This review process should include procedures for identifying and mitigating the financial institutions’ conflicts of interest associated with investment products or, alternatively, declining to recommend a product if the financial institution cannot effectively mitigate associated conflicts of interest sufficiently to promote compliance with the Impartial Conduct Standards.

Generally speaking, financial institutions have two types of conflicts for this purpose. The first relates to compensation that is shared with the investment professionals, for example, fees for advice or commissions for transactions. The second is where the financial institution receives compensation that is not shared with the investment professionals, for example, revenue sharing. (For ease of reference, I refer to “compensation”; however, in DOL-speak, the conflict can be money or anything of monetary value.)

For the first category—where the compensation is shared with the investment professionals, as a general matter the best interest process (that is also required as a condition of PTE 2020-02) will be the first line of defense. A good best interest process developed by the financial institution and implemented by the investment professional will go a long way towards mitigation of any conflicts. Of course, the financial institution must properly supervise the implementation of the process, including the consideration of the costs and their impact on the retirement investors.

In some cases, though, that may not be enough. In that regard, financial institutions should consider firm-level mitigation practices, such as (i) taking steps to ensure that fees and commissions are not more than reasonable amounts and (ii) narrowing the range of commissions for a particular service (e.g., compensation based on front end loads of mutual funds).

For the second category—compensation to the financial institution that is not shared with the investment professionals, the mitigation involves only the firm’s practices. For example, if mutual funds pay revenue sharing to the financial institution or if another service provider makes payments to the financial institution as the result of transactions or assets, the financial institution needs to have practices and policies reasonably designed to ensure that those payments do not incent the financial institution to favor those funds or the transactions that generate the payments. With regard to revenue sharing from mutual funds, one possible approach is for the firm to vet the funds to ensure that the quality of the funds is good and that the costs are reasonable, such that recommendations of those funds by their investment professionals will be in the best interest of retirement investors.

In essence, the mitigation of a firm’s conflicts would require practices that ensure that the firm’s conflicts are not passed through to the investment professionals in a way that could affect the advice given to retirement investors.

Concluding Thoughts

The PTE’s mitigation provision imposes new requirements on financial institutions. For example, broker-dealers must, under Reg BI, mitigate the conflicts of interest of their investment professionals, but are not required by Reg BI to mitigate the firm’s conflicts. Even if the mitigation standard for investment professionals under Reg BI is as demanding as the PTE’s (and it may not be), broker-dealers will still need to mitigate (and develop policies and procedures for) the conflicts at the firm level. For investment advisers, the SEC has not imposed mitigation requirements at either the firm level or the individual level. As a result, investment advisory firms will need to develop mitigation practices to comply with the condition of the PTE, and then incorporate those practices in their written policies and procedures. Time is short. The DOL will begin enforcement as of February 1, 2022.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Faegre Drinker.

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