Best Interest Due Diligence Standard for Advisors # 49 | Faegre Drinker Biddle & Reath LLP
The Ministry of Labor “Fiduciary Rule”, PTE 2020-02 (Part 14): The Two Compensation Requirements: Reasonable Compensation and Mitigation
This series focused on the new DOL fiduciary “rule”. This article is the 14th in a sub-series dealing with special or unique compliance issues related to the rule. This article examines issues related to meeting reasonable compensation requirements and rule mitigation, with a particular focus on dealers and investment advisers.
On February 16, 2021, the DOL Prohibited Transactions Exemption (PTE) 2020-02 came into effect. (Improved investment advice for workers and retirees) It enables investment advisers, brokers, banks and insurance companies (“financial institutions”), as well as their representatives (“professionals of the investment ”), to receive conflicting compensation resulting from a non-investment advisory trustee to pension plans, members and IRA owners (“ retirement investors ”).
In the preamble to the PTE, the DOL announced an expanded definition of the board of trustees, which means that many more financial institutions and investment professionals will be trustees and therefore need the protections offered by the exemption. They will also have to meet the standard of care in the best interest. The relief provided by the exemption is conditional, that is, the “conditions” of the exemption must be met to obtain an exemption from the prohibited transactions rules in ERISA and the Internal Revenue Code. For the period February 16 to December 20, a DOL and IRS Non-Enforcement Policy based on the Standards of Impartial Conduct will be available.
This article builds on my previous posts: Part 11, Mitigation; Part 12, Reasonable Compensation; and Part 13, Two Compensation Requirements. Compensation and mitigation are related in the sense that unreasonably high compensation would be difficult to mitigate.
On April 13, 2021, the DOL published a series of frequently asked questions (FAQs) on PTE 2020-02 and the expanded definition of board of trustees. In FAQs 16 and 17, the DOL discussed mitigating the incentive effect of conflicts of interest. My last article (part 13) dealt with the obligation to mitigate conflicts of interest of investment professionals. This article discusses the requirement to mitigate conflicts of financial institutions (for example, the broker or the RIA company). The mitigation measures developed by brokers to comply with Reg BI’s conflict obligation for their investment professionals will be helpful in complying with the DOL mitigation requirements for investment professionals. And, in some cases (as explained below), these metrics will be helpful in complying with DOL mitigation requirements for the brokers themselves. However, the RIAs are in a different boat. The SEC has not imposed a mitigation requirement on investment advisers, either for investment professionals or for companies. As a result, RIAs will need to develop mitigation processes, policies and procedures, as well as monitoring practices for business and individual conflicts.
The requirement of the rule that financial institutions mitigate their conflicts is explained in FAQ 16:
Q16. The exemption requires that the policies and procedures of financial institutions 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 an investment professional. put their interests ahead of those of the retired investor. What should financial institutions do to meet this mitigation standard?
In response, the DOL provided the following response regarding the financial institution’s disputes:
Conflicts between financial institutions. The policies and procedures of financial institutions should also address and mitigate financial institutions’ own conflicts of interest, including establishing or improving the review process to determine which investment products can be recommended to retired investors. This review process should include procedures to identify and mitigate conflicts of interest of financial institutions associated with investment products or, failing that, to decline to recommend a product if the financial institution cannot. effectively mitigate associated conflicts of interest sufficient to promote adherence to standards of impartial conduct. .
To help develop compliant mitigation practices, financial institutions should consider dividing their conflicts into two categories:
- Conflicts that also impact their investment professionals. For example, these can include rollover recommendations and commission sales. In these situations, a recommendation from an investment professional may result in increased compensation for both the financial institution and the investment professional. And, in most of these cases, the techniques developed to lessen the incentive effect of the professional recommendation would also lessen the conflict for the financial institution.
- Conflicts that do not result in increased compensation for investment professionals. An example would be revenue sharing payments from insurance companies, mutual funds, custodians, and other service providers that are not shared with investment professionals. Another example would be the exclusive investments managed by the financial institution or an affiliate. In these cases, the financial institution should mitigate the incentive effect of conflicts so that the recommendations made by their professionals are in the best interest of the plans, the members or the owners of IRAs.
Fortunately, the DOL recognizes that mitigation can be achieved by a variety of techniques and that the measures may vary depending on the nature of the particular recommendation and the associated conflict. These measures could include the processes used to develop the recommendation, reduce pay gaps and oversight. However, as a warning, the onus of proving compliance with the mitigation requirement lies with the financial institution. Accordingly, financial institutions should carefully consider whether their mitigation techniques meet the PTE 2020-02 standard:
The policies and procedures of financial institutions mitigate conflicts of interest as long as a reasonable person reviews the policies and procedures and incentive practices as a whole conclude that they do not create an incentive for a financial institution or investment professional to put their interests ahead of those of the retired investor.
It is possible that this standard is more demanding than the mitigation requirements under the conflict obligation in Reg BI, leaving “mitigate” largely undefined.: Identify and mitigate any conflict of interest associated with such recommendations which encourage a natural person who is an associate of a broker or broker to put the interests of the broker, broker or such natural person before the interest of the retail client;….
Before leaving this topic, I must point out another difference. While Reg BI covers “retail clients” (which includes IRA participants and owners), DOL’s PTE 2020-02 covers IRA plans, participants and owners. As a result, brokers will need to increase their mitigation policies and procedures to include recommendations to pension plans governed by ERISA. And, as explained earlier, RIAs will need to develop compliant policies and procedures that cover all three types of “retired” clients: pension plans, members, and IRA owners.
My next article will cover some of the mitigation techniques discussed by the DOL in the Preamble to PTE 2020-02 and in the FAQs.