The U.S. Department of Labor has released its package of proposed changes to the regulation defining fiduciary advice and to the exemptions for conflicts and compensation for investment recommendations to retirement plans, participants (including rollovers), and IRAs (including transfers).

When a person makes a “covered” recommendation to a “retirement investor” and the recommendation, when implemented, results in the person (or his or her firm) receiving additional compensation, a prohibited transaction (under the Code and ERISA) will occur.

A “covered” recommendation is one in which the person is a fiduciary (as defined in the proposed fiduciary recommendation) and which falls into one of the three defined categories. Those categories include, for example, recommendations about investing in securities or annuities, rollovers, IRA transfers, withdrawals from retirement accounts, and investment strategies, policies and allocations.

The proposed regulation defines a “retirement investor” as a: …plan, plan fiduciary, plan participant or beneficiary, IRA, IRA owner or beneficiary or IRA fiduciary (retirement investor). (In a future article, I will discuss the definition of “IRA fiduciary” and “plan fiduciary” as it applies to wholesalers and others who may unknowingly fall into those categories.)

While those covered and conflicted recommendations are literally prohibited, there are “conditional” exemptions (which could conversationally be called exceptions). The exemptions (referred to as PTEs) are “conditional” in the sense that the conditions in the PTEs must be satisfied to obtain the protection afforded by the exemption. Generally speaking, the conditions of the two primarily available exemptions (84-24 and 2020-02) fall into four categories:

• The Impartial Conduct Standards
• Pre-transaction Disclosures
• Policies and Procedures
• Annual Retrospective Review

However, there two other important parts to the PTEs. The first is a requirement to correct any identified failures by fiduciary advisors or agents (or their firms) to comply with the conditions and the second is “eligibility” (which refers to the possibility of loss of the ability to use the exemptions; in that case, the exemptions  would no longer be available as relief from the prohibitions and compensation from conflicted fiduciary recommendations would be prohibited).

One of the requirements is that, when a failure to satisfy the conditions is identified in the annual retrospective review, the failure must be corrected and reported to the DOL. For the period between the time of the failure (e.g., the failure to engage in a best interest process to develop the initial recommendation) and the time of correction, the compensation earned due to the fiduciary recommendation must be treated as a prohibited transaction and reported to the IRS on a Form 5330, and the excise taxes must be paid.

That requirement was not in the current versions of PTEs 2020-02 or 84-24, but is being added to the proposed versions of both.

In the Retrospective Review part of proposed PTE 2020-02 (and in a similar provision in the proposed 84-24), it says that, for the report based on the review, a Senior Executive Officer must certify, among other things, that:

The Financial Institution has filed (or will file timely, including extensions) Form 5330 reporting any non-exempt prohibited transactions discovered by the Financial Institution in connection with investment advice covered under Code section 4975(e)(3)(B), corrected those transactions, and paid any resulting excise taxes owed under Code section 4975;… [The emphasis is mine.]

To make matters even worse, the PTE says, in its Eligibility provisions, that the eligibility to use the PTEs can be forfeited if the advisor or agent, or the financial institution is:

…engaging in a systematic pattern or practice of failing to correct prohibited transactions, report those transactions to the IRS on Form 5330 and pay the resulting excise taxes imposed by Code section 4975 in connection with non-exempt prohibited transactions involving investment advice under Code section 4975(e)(3)(B);…

In other words, a systematic pattern of failing to file and pay could result in loss of eligibility to use the exemptions. To emphasize the significance of this, some people are referring to the loss of eligibility as the “death penalty.”

However, that is not the end of the story. Note that these requirements apply to “non-exempt prohibited transactions”. In the Self-Correction provisions of the PTEs, there is an opportunity to avoid having a prohibited transaction treated as non-exempt. For example, PTE 2020-02 says:

Self-Correction

A non-exempt prohibited transaction will not occur due to a violation of the exemption’s conditions with respect to a transaction, provided:

1. Either the violation did not result in investment losses to the Retirement Investor or the Financial Institution made the Retirement Investor whole for any resulting losses;
2. The Financial Institution corrects the violation and notifies the Department of Labor of the violation and the correction via email to IIAWR@dol.gov within 30 days of correction;
3. The correction occurs no later than 90 days after the Financial Institution learned of the violation or reasonably should have learned of the violation; and
4. The Financial Institution notifies the person(s) responsible for conducting the retrospective review during the applicable review cycle and the violation and correction is specifically set forth in the written report of the retrospective review required under subsection II(d)(2).

Considering the draconian consequences, it goes without saying that broker-dealers, registered investment advisers, banks, and insurance companies should make every effort to comply with these correction and disclosure requirements and the time limits. Obviously, firms need to have policies and practices for this purpose.

That’s enough for today. My next few articles will be about the correction requirements.

Concluding Thoughts

This new provision in the proposed PTEs was unexpected.

On reflection, though, the requirement to file a Form 5330 and pay any required excise taxes has always been there. In that sense, the Self-Correction language in the proposed PTEs is actually relief—even though it may not feel like it. It would be helpful, though, if there was a “reasonable cause” exception if the time limits were missed. Right now, the proposed language is unforgiving, but it should not be.

Hopefully, the DOL will be reasonable in its administration of the Eligibility provision generally and specifically with regard to the Form 5330 requirement. If a firm is largely in compliance, but makes a mistake, the DOL would not treat that as an eligibility issue. My concern, though, is that with larger firms there can be systems errors that are inadvertently repeated many times before being caught and corrected. The system needs to be forgiving if the compliance efforts have been substantial.

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.