The Department of Labor’s “Fiduciary Rule”, PTE 2020-02 (Part 11): The Requirement that Investment Advisers and Broker-Dealers Mitigate Conflicts

On February 16, 2021, the DOL’s prohibited transaction exemption (PTE) 2020-02 became effective. The PTE is titled “Improving Investment Advice for Workers & Retirees.” It 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 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 and therefore will need the protections afforded by the exemption. In addition, they will need prudent, or best practice, processes to satisfy the fiduciary and best interest standards of care.

In order to obtain the benefit of the exemption, financial institutions and investment professionals will need to satisfy the “conditions” in the exemption. For the period from the effective date (February 16) until December 20 of this year, a DOL and IRS non-enforcement policy for prohibited transactions will be available in lieu of the exemption. That is, neither the IRS nor the DOL will enforce the rules against transactions with plans, participants or IRA owners that result from nondiscretionary fiduciary advice and that are prohibited in the Code or ERISA, so long as the Impartial Conduct Standards are satisfied. See Best Interest #41 for a discussion of the Impartial Conduct Standards.

This article builds on my earlier posts about the DOL’s rule, Parts 1-10.

This article is about the requirement in the PTE to “mitigate” conflicts of interest. The exemption’s requirement is:

“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.”

A conflict of interest is defined as:  “… an interest that might incline a Financial Institution or Investment Professional—consciously or unconsciously—to make a recommendation that is not in the Best Interest of the Retirement Investor.”

Compare the DOL’s mitigation requirement to the SEC’s in Regulation Best Interest:

“Conflict of interest obligation. The broker or dealer establishes, maintains, and enforces written policies and procedures reasonably designed to:   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;…”

 There are two notable differences. The first is that the DOL’s mitigation provision applies to both the financial institution and the investment professional, while the SEC’s rule for broker-dealers only requires that the incentives of the investment professional be mitigated. While that is a significant difference, in many cases (but not all cases, e.g., revenue sharing), the mitigation techniques for investment professionals will also provide effective mitigation for the financial institution, e.g., a “best interest” recommendation that generates a commission for the financial institution that is shared with the investment professional. As a result, broker-dealers will need to augment their Reg BI written policies and procedures to address mitigation of conflicts at the firm level (and other “financial institutions,” e.g., investment advisers, will need to develop mitigation policies and procedures for both the individual advisers and the firm).

The other notable difference is that the DOL provides a more detailed definition of the expected outcome of the mitigation. It says: “…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…”.

While that may make sense in writing, it may not as a practical matter. For example, can a commission be so mitigated, or dampened, that it does not provide any incentive for an investment professional to place his or her interest ahead of an investor’s? To the extent that the language suggests that the incentive effect of a commission must be eliminated, it may create an impossibility. However, I expect that the provision will be interpreted to mean that the mitigation techniques must be reasonably designed to prevent an investment professional from succumbing to the incentive.

The moral of this story is that, while many of the provisions in PTE 2020-02 are based on the SEC’s Reg BI, the PTE requires more than Reg BI does. In other words, compliance with Reg BI will not, in and of itself, satisfy the requirements of the PTE.

Also, as a word of caution, the references to Reg BI are not meant to limit the scope of this article or of the DOL’s mitigation requirements to broker-dealers. Those requirements also apply to other “financial institutions” that make rollover recommendations, including investment advisers and banks and trust companies. For example, investment advisors—as well as the other “financial institutions”–will need to have mitigation practices and written policies and procedures to implement this requirement. In addition, they will need to perform the annual retrospective review of compliance with those practices, policies and procedures. That will likely be demanding for smaller firms.