In their latest post published to Stradley Ronon’s fiduciary governance blog, two ERISA [Employee Retirement Income Security Act] specialists with the firm break down the Department of Labor (DOL)’s recently published frequently asked questions (FAQ) document, which covers the prohibited transaction exemption (PTE) regulation finalized last year.
The post, from attorneys George Michael Gerstein and John Dikmak Jr., explains that the Biden administration’s regulatory freeze has not impacted the rollout of the PTE, despite its finalization late in the Trump administration, so it is very important for advisers to review the new guidance.
By way of background, the PTE was finalized in December and took effect in mid-February, despite President Joe Biden’s election and the installation of new leadership at the DOL. It is generally applicable to registered investment advisers (RIAs), broker/dealers (B/Ds), insurance companies, banks and individual investment professionals who are their employees or agents.
Broadly speaking, the exemption permits investment advice fiduciaries to receive compensation as a result of providing fiduciary investment advice, including fiduciary investment advice to roll over a participant’s account in an employee benefit plan to an individual retirement account (IRA)—among other similar types of rollover recommendations. The exemption also permits investment advice fiduciaries to enter into “principal transactions” in which they could sell or purchase certain securities and other investments from their own inventories to or from plans and IRAs.
The DOL stipulates the proposed class exemption would require fiduciary investment advice to be provided in accordance with the following criteria: “A best interest standard, a reasonable compensation standard and a requirement to make no materially misleading statements about recommended investment transactions and other relevant matters.” Ostensibly, by complying with the Securities and Exchange Commission (SEC)’s Regulation Best Interest (Reg BI), advisers or other investment professionals will satisfy all of these criteria.
Of course, actually implementing the PTE comes with a significant degree of complexity, and so the DOL has published the new FAQ.
Such guidance documents themselves are rarely straightforward, which is why attorneys like Dikmak and Gerstein often present their own analyses. As the pair summarizes, the PTE’s transition period allows parties to devise mechanisms to comply with the provisions in the exemption any time before December 20, 2021. In the FAQ, the DOL hints at further sub-regulatory guidance and the potential for once again overhauling the fiduciary investment advice regulation. However, no promises were made or timetables offered, Gerstein and Dikmak note.
“The DOL reiterates that a ‘single, discrete instance of advice to roll over assets from an employee benefit plan to an IRA’ would generally not give rise to investment advice under ERISA,” the attorneys write. “But, such communication could constitute investment advice if it were part of an ongoing relationship or the beginning of an intended future ongoing relationship that an individual has with the investment advice provider.”
This is a very important distinction, and one that might not be fully appreciated by those who have merely skimmed the PTE, they say. Relatedly, the DOL FAQ reminds the industry that boilerplate, fine print disclaimers that investment advice is not being provided generally won’t cut it.
“This echoes the sentiment the DOL expressed in 2020,” Gerstein and Dikmak say. “However, written statements disclaiming a ‘mutual’ understanding or forbidding reliance on the advice as ‘a primary basis for investment decisions’ may be considered in determining whether a mutual understanding exists, but such statements will not be determinative.”
According to the attorneys, ultimately, the determination of whether there is a “mutual” understanding that investment advice is being provided will be based on the totality of the facts and circumstances. Furthermore, investment professionals and financial institutions can provide such investment advice, despite having a financial interest in the transaction, as long as the advice meets the best interest standard.
“Under this standard, the advice must be based on the interests of the customer, rather than the competing financial interest of the investment professional or financial institution,” the attorneys explain. “Investment professionals may receive payments for their advice within this framework.”
Among other points made in the post, the attorneys go on to emphasize that 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.
“With carefully considered compensation structures, financial institutions can avoid 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,” the attorneys write. “Thus, quotas, bonuses, prizes and performance standards are likely out. On the flip side, a financial institution could provide level compensation for recommendations to invest in assets that fall within reasonably defined investment categories (e.g., mutual funds), and provide 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.”