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Best Interest Due Diligence Standard for Advisors # 51 | Faegre Drinker Biddle & Reath LLP

By on May 26, 2021 0

The Ministry of Labor “Fiduciary Rule”, PTE 2020-02 (Part 16): Mitigation Strategies


This series focuses on the new fiduciary “rule” of DOL. This article is the 16th in a sub-series dealing with specific compliance issues related to the rule. This article examines compliance with the rule’s mitigation requirements, with a particular focus on dealers and investment advisers.


On February 16, 2021, the DOL Prohibited Transactions Exemption (PTE) 2020-02 came into effect. (Improving investment advice for workers and retirees) It allows investment advisers, brokers, banks and insurance companies (“financial institutions”) and their representatives (“investment professionals”) to receive conflicting compensation resulting from unrelated fiduciary investment advice. discretionary 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 for by the exemption is conditional, ie the “conditions” of the exemption must be met to obtain the exemption from the rules on prohibited transactions of ERISA and 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 articles: Part 11, Mitigation; Part 12, Reasonable compensation; Part 13 and Part 14, Two pay requirements, and Part 15, Mitigation strategies.

Mitigation measures developed by brokers to comply with Reg BI’s conflict obligation will be useful in complying with DOL mitigation requirements for investment professionals. And, in some cases (as explained below), these metrics may be useful in meeting DOL mitigation requirements for financial institutions subject to Reg BI (i.e. for brokers).

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. Accordingly, RIAs will need to develop mitigation processes, policies and procedures, as well as monitoring practices for internal and individual conflicts.

As a reminder, the mitigation requirement in the TEP is:

Policies and Procedures of Financial Institutions [must] 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 put forward his interests before that of the retired investor. .

My last article dealt with offsetting grid mitigation strategies and the related discussion in the FAQ 2020-02 issued by the DOL. This article focuses on the mitigation techniques discussed in the preamble to the PTE, where the DOL said:

By developing compliance structures, the Department expects financial institutions to turn to conflict mitigation strategies identified by other regulators of financial institutions. For information only, Here are non-exhaustive examples of practices identified as options by the SEC that could be implemented by financial institutions to compensate investment professionals.:

(1) avoid pay thresholds that disproportionately increase pay through incremental increases in sales;

Comment: In my last post, I discussed the DOL Compensation Grids FAQ. He provided DOL’s perspective on steps that could be taken to reduce any inappropriate incentives created by increased compensation due to reaching production levels in a network.

(2) minimize compensation incentives for employees to favor one type of account over another; or to favor one type of product over another, proprietary products or preferred suppliers, or comparable products sold primarily, for example by establishing differential compensation based on neutral factors;

Comment: This has already been seen with the Obama-era best-interest contract exemption, where a “factor-neutral” approach was used to justify the differences in pay levels between different categories of investments. Unfortunately, it was difficult to calculate the differences in effort, sophistication, etc., in order to justify different remuneration between different products and types of investments. Therefore, I doubt that many financial institutions rely solely on neutral factors to justify the pay differentials. However, the broad concept is feasible in that different remuneration levels for different types of investments could be justified by neutral factors, for example, the effort and expertise of the financial institution and the investment professional, when these factors are combined with good investment selection processes and account types, as well as appropriate supervision. In other words, I doubt that neutral factors alone will be used widely, if at all, but the concept can be used in combination with other practices. Clearly, however, the larger the pay gap, the more pressure it puts on mitigation strategies.

(3) eliminate compensation incentives within comparable product lines, for example by capping the credit that an Associate can receive on mutual funds or other comparable products between vendors;

Comment: By eliminating the differences in remuneration for a particular product line (for example, mutual funds), the incentive effect of recommending one fund over another is eliminated. Therefore, the theory is that the sole interest of the investment professional will be to select the investment or strategy that is in the best interest of the retirement investor. However, it may be sufficient to limit the differences to relatively small ranges. For example, if the initial charges for A-share mutual funds are between 4% and 5%, there would be little incentive (except for very large investments) to prefer one fund over another for to advance the financial interests of the company. investment professional. But, with the narrow range approach, there would still need to be proper supervision, especially when large sums are invested.

(4) implement monitoring procedures to follow the recommendations which are: close to the compensation thresholds; close to the recognition thresholds for companies; involve higher remunerative products, exclusive products or transactions on a principal basis; or involve the rollover or transfer of assets from one type of account to another (such as recommendations to transfer or transfer assets from a Title I plan account to an IRA) or product class to another;

Comment: This is similar to the discussion in my last post regarding the DOL Grid Incentive Mitigation FAQ. With respect to rollover recommendations (and other recommendations where the financial institution and investment professional will gain nothing if the recommendation is not accepted by the retirement investor), the incentive cannot be mitigated by eliminating or reducing pay gaps. Accordingly, the incentive effect of these types of recommendations should likely be mitigated by well-defined, appropriate and possibly documented processes for making the recommendation, as well as closer oversight.

(5) adjust the remuneration of associates who fail to adequately manage conflicts of interest; and

Comment: The justification for this mitigation technique seems obvious. Failure to follow a company’s processes and policies must have consequences. It is one way to deal with conflict issues in the future.

(6) limit the types of retail customers to whom a product, transaction or strategy can be recommended.

Comment: Although the rationale is not clear, it may apply to more complex, less transparent and higher paying investments, especially for recommendations to retired investors who do not have the experience or knowledge to understand investments.

Final thoughts:

Compliance with mitigation requirements (for both investment professionals and financial institutions) will be demanding. In most cases, the key will be the process of developing recommendations to the retirement investor. A good process, properly supervised, will often, by itself, mitigate the incentive effect of any pay gap.

But mitigation is a principled approach. This requires a balance of approaches, which, taken together, would be considered by a reasonable person to effectively mitigate the incentive effect of compensation (and in particular transaction-based compensation) so that any recommendation is in the best possible way. interest of the investor (and not primarily in the interest of the investment professional). This requires a risk-based analysis. He also suggests that mitigating “solutions” be reviewed by someone outside the financial institution. The internal approach of a financial institution could be to continue operations as usual. But, compliance with PTE 2020-02 requires changes to existing practices.

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