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Best Interest Standard of Care for Advisors #75: Compliance with PTE 2020-02: Mitigation of Conflicts (Part 2) | Faegre Drinker Biddle & Reath LLP

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

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. This post focuses on mitigation of the conflicts of the investment professional.

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’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.

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. After that general discussion, the FAQ’s answer goes on to talk about the requirements that apply specifically to investment professionals:

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.

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.

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. However, in many circumstances, supervisory oversight is not an effective substitute.

Commentary:  Let’s look at some of the examples that the DOL uses for mitigation of the conflicts of investment professionals:

  • …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 concept is that “quotas, bonuses, prices, or performance standards” could incent investment professionals to make recommendations that qualify them for rewards under those programs—even if the recommendation was not in the best interest of the retirement investor. The greater the value of the award, the more likely it is to incent recommendations that favor the investment professional (even if not in the best interest of the retirement investor), and therefore more difficult to mitigate. On the other hand, relatively minor payments or benefits would be less likely to incent a recommendation that is not in the best interest of a retirement investor and, as a result, the mitigation efforts need not be as demanding. One approach is for financial institutions to design their reward programs with smaller incremental steps for qualification for rewards and with more limited benefits for reaching each of those incremental steps–and then to have enhanced supervision as the investment professionals approach the incremental qualifying levels.

  • …a firm could ensure level compensation for recommendations to invest in assets that fall within reasonably defined investment categories (e.g., mutual funds),…

    In this case, a financial institution could “levelize” the compensation for all mutual fund recommendations, even if the firm’s compensation varied some. Of course, that would be easier to communicate (and possibly generate less pushback), if the firm received level compensation for sales of mutual funds and shared the compensation with its investment professionals according to the previously established splits.

  • …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.

    The Obama-era Best Interest Contract Exemption required the use of “neutral factors” for differing investment categories. That is changed under 2020-02 (although neutral factors would satisfy the new rule). Instead, PTE 2020-02 relies on a fairly demanding best interest standard (that is, a combination of ERISA’s prudent man rule and duty of loyalty) for determining which category (or account type) is in the best interest of the retirement investor and which product within that investment category is in the best interest of the retirement investor. The rule also requires “heightened” supervision of the recommendation of investment categories to the extent that there is differential compensation. If the compensation differential is slight, there is less likelihood of an adverse incentive for the investment professional, but the inverse is true as well (that is, if the compensation differential is significant, both the best interest process and the degree of supervision will likely be more closely examined).

  • …financial institutions’ policies and procedures could provide for increased monitoring of investment professional recommendations…at key liquidity events for investors (e.g., rollovers),…

    There are conflicts that cannot be mitigated by levelizing compensation or reducing the differences in compensation. One example is a plan-to-IRA rollover recommendation. If the retirement investor accepts the recommendation, the firm and the investment professional will be compensated from the rollover IRA, but if the retirement investor does not roll over the plan benefits, the firm and the investment professional will not make any money. In these cases, the first line of “defense” is to have a well-defined and documented process for evaluating the “relevant” information and making an informed and reasoned decision in the best interest of the retirement investor. Then those recommendations could be subject to “heightened” supervision. While there is little direct guidance on how to mitigate these “all or nothing” recommendations, it seems likely that the strength of the process (including the information reviewed and considered as a part of that process) and the degree of supervision will be important elements of mitigation.

  • However, in many circumstances, supervisory oversight is not an effective substitute.

    Apparently the DOL is concerned that some financial institutions may be contemplating relying only or primarily on supervision as their mitigation practice. As a result, the DOL gave this admonition at the end of the examples. This caveat should be viewed as a shot across the bow of firms that are considering that approach.

Concluding Thoughts

There is a good chance that the DOL (and the SEC) will, in the next year or two, focus their examinations on the mitigation practices of broker-dealers, investment advisers and other financial institutions. And their views about mitigation may differ from the private sector’s—in the sense that the regulators may expect more than is anticipated.

A number of the provisions in the DOL’s PTE (and the SEC’s Reg BI and Investment Adviser Interpretation) are principle-based (and therefore not defined in the sense that rules-based guidance is). Among those principles are “mitigation” and “best interest”. If the DOL and SEC examine financial institutions with demanding definitions of those terms, the financial institutions will, in a sense, be subject to “regulation by examination”. But that is the nature of principles-based standards. To avoid that outcome, financial institutions should consider using conservative best interest and mitigation practices.


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