Requirements of New Prohibited Transaction Exemption PTE 2020-02
Investment Advisor Fiduciaries[i] who provide investment advice to either ERISA-covered pension plans, and/or individual retirement accounts (“IRAs”), must protect the interests of their investors and avoid prohibited transactions[ii] unless statutory exemptions exist.
On December 18, 2020, the U.S. Department of Labor’s new Prohibited Transaction Exemption 2020-02 (“PTE”) became effective.[iii] Fiduciaries who rely on this exemption can receive compensation that would otherwise be prohibited[iv] if they render advice that is within the best interests of their ERISA-covered and IRA customers. To benefit from this exemption, the fiduciary will need to demonstrate and document the reasons why the otherwise prohibited transaction was in fact in a client’s best interests. The following gives more detail as to the new PTE requirements.
1. Impartial Conduct Standards
PTE 2020-02 only provides prohibited transaction relief for those providing advice in accordance with the Impartial Conduct Standards. The Impartial Conduct Standards are consumer protection standards which ensure adherence to fiduciary norms and basic standards of good faith and fair dealing. The Impartial Conduct Standards have three parts: (1) a best interests standard; (2) a reasonable compensation standard; and (3) a requirement to make no misleading statements about investment transactions and other relevant matters.[v] To rely on the PTE exemption, the firm must also affirmatively demonstrate - and document - why its recommendation is in the client’s best interest (i.e., objective “A vs. B” analysis) when recommending rollover transactions.
a. “Best Interests” Standard
This best interest standard can be reduced to two concepts: prudence and loyalty.[vi] Under the prudence standard, the advice must meet a professional standard of care such that the advisor, despite the conflict of interest inherent in the prohibited transaction, would act in the same way as an impartial professional would have. This standard applies to investigations and evaluations of investments, advice provided, and the exercise of sound judgement. Under the loyalty standard, the advisor must not subordinate the client’s interests to their own, or otherwise place their own interests, or those of their affiliates, above the interests of the investor.
b. “Reasonable Compensation” Standard
Advisors may only charge compensation that would be considered reasonable in the industry and must comply with all federal securities laws regarding “best execution” of transactions. The Department of Labor identified that firms and institutions using a payout grid for calculating investment professionals’ compensation, or other differential compensation schedule, could encounter greater regulatory scrutiny.[vii] One concern is that compensation based on a fixed percentage of the commission generated by the institution has the effect of transmitting firm-level conflicts of interest to the professional. Graduated compensation schedules with fewer large step increases, rather than those with many smaller thresholds, create stronger incentives to compromise standards to reach the next tier. If the advisors are highly rewarded for generating the greatest compensation for the firm, it makes it less likely that an advisor’s recommendations are consistent with the Impartial Conduct Standards.
c. “No Misleading Statements” Requirement
Advisors must not make misleading statements about investment opportunities, transactions, conflicts of interest, fees, or other relevant matters. In addition to other established forms of accountability, the PTE 2020-02 exemption becomes unavailable for a period of ten (10) years to professionals who have “engaged in systematic or intentional violation of the exemption’s conditions or provided materially misleading information to the Department in relation to their conduct under the exemption.”[viii]
2. Perform Rollover Analysis
In its release, the Department of Labor put a spotlight on rollover transactions.[ix] When an Investment Advisor Fiduciary recommends to a client that the client roll over retirement plan assets into an account managed by the firm, it creates a de facto conflict of interest and a prohibited transaction. The conflict arises because the advisor charging fees will financially benefit by, and therefore has an interest in, recommending that a client roll over an ERISA-protected retirement plan into an IRA managed by the advisor. This type of prohibited transaction can be exempted using the new PTE.
A rollover analysis will focus on comparing the client’s current position to the position the client will be in after the roll over. The firm should compare services available under each option, and associated fees and expenses, as evidenced in such documents as summary plan descriptions, account statements, client agreements, and applicable compliance disclosures.[x] The CCO must then approve the analysis. Finally, the firm must present the rationale for recommending the rollover in writing to the client, along with a request to review and acknowledge that the client considered all the factors raised by the firm when exercising their own discretion to make their determination. If the available information is not sufficient to establish a basis for recommending a rollover, the firm should not recommend one.
3. Deliver Written Disclosures
The fiduciary nature of the relationship between the advisor and investor must be acknowledged in writing to the investor before the firm relies on PTE 2020-02 to exempt a prohibited transaction, such as by recommending a rollover. The Department of Labor expects that those who would take advantage of this broad new exemption should recognize their elevated duty as a fiduciary from the start of the relationship. The written acknowledgement must not be overbroad or ambiguous, such that a reasonable investor would be clear on which recommendations are given in a fiduciary capacity. It should state that the firm or advisor has determined that it is a fiduciary, it is rendering advice as a fiduciary, and therefore it has decided to follow the exemptions conditions.[xi] Either here, or in other disclosures (e.g., Form ADV 2A), the advisor should also include a written description of the services provided and the advisor’s material conflict of interests.
4. Update Firm Policies and Procedures
Advisors will need to develop policies and procedures (“P&Ps”) to cover activities and the processes used to comply with PTE 2020-02. In addition, advisors must periodically and reasonably review their P&Ps to satisfy the conditions of PTE 2020-02. The P&Ps should be designed to ensure compliance with the Impartial Conduct Standards and include the approved procedure for making and documenting rollover recommendations. The conflict mitigation and supervisory oversight provisions should therefore receive special scrutiny upon internal review. The P&Ps should 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.”[xii]
5. Conduct Retrospective Review Annually
PTE 2020-02 requires that advisors conduct a retrospective review that is reasonably designed to: (1) detect and prevent violations of the Impartial Conduct Standards, and (2) achieve internal compliance with the P&Ps enacting those Impartial Conduct Standards. The retrospective review document consists broadly of two components, the methodology and the results.
a. Content of Retrospective Review Report
The methodology section will provide the details of the process by which the review was conducted. The content will include all information relevant to fully describing how the review is “reasonably designed” to achieve the stated goals. Here, the advisor should elaborate on sources of the data, data collection or selection procedures, the measures taken to analyze that data, the parties responsible for the process, and any other relevant details. This section should also be adjusted over time to recognize any updates the Department of Labor makes to the requirements of the exemption. If reduced to a template, the template should reflect updates relating to the rule and its requirements.
The results section should present the data, analysis, and findings of the review in a way that tracks the methodology described. Generally, the content should present what was learned and why it matters. This section should also present any specific detections of violations of the Impartial Conduct Standards and related policies and procedures, and their resolutions. The expectation is that advisors will “use the findings of the review to find more effective ways to help ensure that investment professionals are providing investment advice in accordance with the Impartial Conduct Standards and to correct any deficiencies in existing policies and procedures.”[xiii] Consequently, this section will change the most from year to year.
b. Timeline
Once the retrospective review has been reduced to a written report, at least one member of the senior executive management (CEO, President, CCO) must review and approve it. The reviewing officer will then certify that: (1) the officer has reviewed the retrospective review report, (2) the advisor does in fact have in place sufficient P&Ps, prudently designed to achieve compliance with the conditions of PTE 2020-02, and (3) the advisor also has in place prudent processes to modify and update such P&Ps, and to test their effectiveness on a reasonably regular basis.[xiv]
The retrospective review, the written report, and officer certification must be completed no later than six months following the end of the review period. Each retrospective review should cover the trailing 12-month period. The initial retrospective review will cover February 1, 2022, through January 31, 2023, and must be completed by July 30, 2023.
Conclusion
For advisors who wish to rely on PTE 2020-02, it is already time to start rollover documentation and required disclosures of fiduciary status. Updates to P&Ps related to rollover documentation, required disclosures, and codification of the Impartial Conduct Standards should already be in place. The advisor’s Form ADV should also include a rollover paragraph. Starting January 31, 2022, the Department of Labor has begun pursuing prohibited transaction claims against investment advice fiduciaries in violation of PTE 2020-02; however, the Department agreed not to enforce rollover documentation and disclosure requirements until June 30, 2022.
If you need help determining how your firm can become eligible to use PTE 2020-02, or analyzing and responding to a possible violation,[xv] we are here for you.
If you have questions about PTE 2020-02, or about other compliance or legal matters, we are here to help.
Shustak Reynolds & Partners, P.C. focuses its practice on securities and financial services law and complex business disputes.
We represent many broker-dealers, registered representatives, investment advisors, investors, and businesses.
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[i] An “Investment Advisor Fiduciary” meets the following conditions and receives compensation for such service: (1) render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing, or selling securities or other property (2) on a regular basis (3) pursuant to a mutual agreement, arrangement, or understanding with the Plan, Plan fiduciary or IRA owner, that (4) the advice will serve as a primary basis for investment decisions with respect to Plan or IRA assets, and that (5) the advice will be individualized based on the particular needs of the Plan or IRA. 29 CFR 2510.3-21(c)(1), 26 CFR 54.4975-9(c).
[ii] Generally, prohibited transactions are those in which: fiduciaries are found to “self-deal,” the retirement plan transacts with a disqualified person, or the fiduciary receives kickback payments for making deals on behalf of ERISA plan or IRA. “Self- dealing” means dealing with the income or assets of an ERISA plan or IRA in his own interest or for his own account. ERISA § 406(b)(1).
[iii] The Department of Labor has authority under ERISA § 408(a) and IRC § 4975(c)(2) to grant administrative exemptions from the prohibited transaction provisions.
[iv] Includes: commissions, 12b-1 fees, revenue sharing, and mark-ups and mark-downs in principle transactions. New Fiduciary Advice Exemption: PTE 2020-02 Improving Investment Advice for Workers & Retirees Frequently Asked Questions (“PTE 2020-02 FAQ”) at 1, Department of Labor EBSA, April 2021.
[v] PTE 2020-02 FAQ at 2.
[vi] PTE 2020-02 FAQ at 10.
[vii] PTE 2020-02 FAQ at 12.
[viii] PTE 2020-02 FAQ at 16.
[ix] Federal Register, 85 FR 82798, Vol. 85, No. 244, Prohibited Transaction Exemption 2020-02, Improving Investment Advice for Workers & Retirees (12/19/2020).
[x] Whichever documents the firm relies on to form the basis of its rollover recommendation should be retained for five (5) years, counting from the end of that year.
[xi] The Department of Labor provided boilerplate language to insert into the fiduciary acknowledgement as a preamble. PTE 2020-02 FAQ at 9.
[xii] PTE 2020-02 FAQ at 11.
[xiii] PTE 2020-02 FAQ at 15.
[xiv] PTE 2020-02 FAQ at 15.
[xv] The new exemption provides self-correction procedures when a violation occurs. The correction must occur with 90 days of discovery, and the Department of Labor must be notified ([email protected]) within 30 days of the correction.
