If Caught Off Guard by a Failure

Art by Tim Bower

Question: I’m a registered investment adviser who works with individuals. When I recommend that a plan participant roll over his or her account to an individual retirement account that I’ll manage, I know I must comply with Prohibited Transaction Exemption 2020-02, “Improving Investment Advice for Workers and Retirees,” in order to avoid a prohibited transaction. Still, I’m concerned I’ll overlook satisfying all of the PTE’s requirements. What should I do if I discover a failure to comply?

Answer: The PTE has a self-correction procedure you’ll need to follow to avoid a prohibited transaction. Unfortunately, some conditions of this procedure are difficult to interpret without additional guidance from the Department of Labor.

You aren’t alone in the concern you cite. We’re already seeing a number of PTE failures, including the following:

• Failure to provide an adequate and/or timely fiduciary acknowledgment under the Employee Retirement Income Security Act and/or the Internal Revenue Code;
• Failure to recognize that the PTE is needed for recommending a transfer from an existing IRA with another firm to an IRA with your firm;
• Failure to disclose that plan-to-IRA rollover recommendations and IRA-to-IRA transfer recommendations are conflicts of interest; and
• Starting July 1, failure to disclose the specific reasons why either of the above transactions involving IRAs is in the investor’s best interest.

If you fail to satisfy the PTE’s conditions, your compensation from the rollover IRA is a prohibited transaction. The consequences are costly. A fiduciary adviser who engages in a prohibited transaction must pay back the prohibited compensation, plus lost earnings on that amount. The adviser also needs to file a Form 5330 with the IRS and pay an excise tax of 15% of the amount involved, increased to 100% if the prohibited transaction is not resolved in good time.

Fortunately, if the self-correction process is satisfied—i.e., by meeting the four conditions below—the failure will not be treated as a prohibited transaction:

1) The failure did not result in investment losses to the investor, or, if losses did result, the firm made the investor whole. There is no guidance on what is meant by “investment loss.” It is unlikely this would cover a loss resulting from normal market fluctuations, as long as you prudently selected the investments in the rollover IRA and they were reasonably priced. Yet, it’s possible that investment loss could refer to the increased fees and costs that may result in the rollover IRA. If so, this raises the issue of whether the correction should include the ongoing effect of the such higher expenses.

2) The firm corrects the violation and notifies the DOL to the pertinent facts thereof, via email at IIAWR@dol.gov, within 30 days of correction. This condition can be challenging if there are systemic failures. For instance, let’s suppose you discover that the disclosure form you’ve used for all rollover recommendations lacked the required conflict of interest disclosure. Now you have a widespread failure affecting all rollover recommendations, and you will need to notify the DOL accordingly. The department gives no further explanation as to correcting the violation, but a reasonable interpretation is you would be required to supply the conflicts disclosure to those clients.

3) The correction is made no later than 90 days after the firm learns of the violation or reasonably should have learned about it. The best way to satisfy this condition is to closely supervise or review rollover recommendations. This way, the failure will be discovered and remedied quickly.

4) The firm notifies the person responsible for conducting the retrospective review during the relevant review cycle, and the violation and correction are specifically set forth in the written report. This condition is easy to carry out. The firm should identify in its policies and procedures the person responsible for conducting the retrospective annual review—usually the chief compliance officer—and train staff to report PTE failures to that person.

While it’s important to have good processes and documentation for rollover recommendations, it’s also important to closely supervise such recommendations to ensure the processes are followed and to promptly identify and correct any failures. Hopefully, the DOL will issue guidance to address and clarify the unanswered questions. We will keep you posted.

Fred Reish is chairman of the financial services ERISA practice at law firm Faegre Drinker Biddle & Reath LLP. Joan Neri, a nationally recognized expert in employee benefits law, is counsel in the firm’s financial services ERISA practice.