Best Interest Standard of Care for Advisors #48

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The Department of Labor’s “Fiduciary Rule,” PTE 2020-02 (Part 13): The Two Compensation Requirements: Reasonable Compensation and Mitigation


On February 16, 2021, the DOL’s prohibited transaction exemption (PTE) 2020-02 became effective. (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. They will also need to satisfy the best interest standard of care. The relief provided by the exemption is conditional. That is, the “conditions” in the exemption must be satisfied. For the period from February 16 until December 20, a DOL and IRS non-enforcement policy based on the Impartial Conduct Standards will be available.

This article builds on my earlier posts: Part 11, Mitigation, and Part 12, Reasonable Compensation. They are connected in the sense that unreasonably high compensation would be difficult to mitigate.

On April 13, 2021, the DOL issued a set of Frequently Asked Questions (FAQs) about PTE 2020-02 and the expanded definition of fiduciary advice. https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/our-activities/resource-center/faqs/new-fiduciary-advice-exemption.pdf  In FAQs 16 and 17, the DOL discussed mitigation of the incentive effect of conflicts of interest. In the FAQs, the DOL asked:

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?

 The DOL answers that question, with regard to the conflicts of investment professionals that result from compensation practices, as follows:

Investment professional conflicts. Financial institutions must take special care in developing and monitoring compensation systems to ensure that their investment professionals satisfy the fundamental obligation to provide advice that is in the retirement investor’s best interest. By carefully designing their compensation structures, financial institutions can avoid incentive structures that a reasonable person would view as creating incentives for investment professionals to place their interests ahead of the interest of the retirement investor. Accordingly, financial institutions must be careful not to use quotas, bonuses, prizes, or performance standards as incentives that a reasonable person would conclude are likely to encourage investment professionals to make recommendations that are not in retirement investors’ best interest. The financial institution should aim to eliminate such conflicts to the extent possible, not create them.

 That is a clear signal from the DOL that it will scrutinize quotas, bonuses, prizes and performance standards for the potential of unduly incentivizing investment professionals to put their interests ahead of the interests of retirement investors. If those incentives do unduly encouraging investment professionals to put their interests first, that condition of the exemption would not be satisfied and compensation resulting from the associated recommendation would be prohibited and would need to be restored to the account of the participant/IRA owner. To compound matters, under the prohibited transaction rules, the burden of proving that the condition was satisfied is on the financial institution.

The DOL’s answer continues:

The Department recognizes that firms cannot eliminate all conflicts of interest, however, and the exemption accordingly stresses the importance of mitigating such conflicts. For example, a firm could ensure level compensation for recommendations to invest in assets that fall within reasonably defined investment categories (e.g., mutual funds), and exercise heightened supervision as between investment categories (e.g., between mutual funds and fixed annuities) to the extent that it is not possible for the institution to eliminate conflicts of interest between these categories. As much as possible, firms should carefully design differences in compensation between categories to avoid incentives that place the interest of the firm or investment professional ahead of the financial interests of the customer. Under this approach, financial institutions would avoid compensation that is likely to incentivize investment professionals to recommend one investment product over another comparable product based on the greater compensation to them or their financial institutions.

 This is reminiscent of the DOL’s approach in the Best Interest Contract Exemption (which was vacated by the 5th Circuit Court of Appeals), with a notable difference. That is, the DOL now seems to be willing to consider mitigation practices other than “neutral factors”. For example, the current guidance will look at supervision and mitigation techniques more broadly, and will probably give more weight to the strength of the process used to make a best interest recommendation (for example, appropriate consideration of the enumerated factors for a rollover recommendation).

One other comment…the leveling of compensation for the financial institution and the investment professional may re-ignite interest in clean shares, where, e.g., broker-dealers can set commission/compensation at the same percentage across the clean shares of mutual fund families.

The DOL answer then continues:

Financial institutions’ policies and procedures must also include supervisory oversight of investment recommendations, particularly in areas in which differential compensation remains. In addition, financial institutions’ policies and procedures could provide for increased monitoring of investment professional recommendations at or near compensation thresholds, recommendations at key liquidity events for investors (e.g., rollovers), and recommendations of investments that are particularly prone to conflicts of interest, such as proprietary products and principal-traded assets.

The “word on the street” is that some broker-dealers plan to rely heavily on their supervisory practices to satisfy the mitigation requirement. But they should consider the DOL’s admonition: “However, in many circumstances, supervisory oversight is not an effective substitute for meaningful mitigation or elimination of dangerous compensation incentives.”

As they say, this is déjà vu all over again. The Obama-era fiduciary rule and BIC exemption contained similar provisions. That approach was picked up by the SEC in Regulation Best Interest, and now here it is again in PTE 2020-02. As a result, broker-dealers should be well-prepared to satisfy at least some of the conditions in the PTE because of their Reg BI compliance efforts. However, the DOL rule requires mitigation at the firm level as well as at the investment professional level, but Reg BI’s mitigation requirements apply only at the level of the investment professional. As a result broker-dealers will need to establish mitigation practices at the firm level for conflicts such as, e.g., proprietary investments and revenue sharing.

On the other hand, while investment advisers generally have fewer conflicts of interest, they need to identify those (e.g., payments from custodians, rollover recommendations, recommendations to transfer IRAs) and develop processes, policies and procedures that are reasonably designed to mitigate those conflicts.

In my next few articles, I will continue the discussion of mitigation requirements and techniques that were described in the DOL’s guidance.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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