The DOL’s Prohibited Transaction Exemption (PTE) 2020-02 applied fully to rollover recommendations and other conflicted fiduciary advice on July 1, 2020. So, the compliance requirements are in place and we can all heave a sigh of relief, right?
Not so fast!
While all of the requirements—the conduct standards, disclosures, and policies and procedures—should be in place and advisors should be implementing the requirements, there are still three important requirements to consider:
• the recordkeeping requirements;
• the self-correction procedures; and
• the annual retrospective review and report.
To complicate matters, the burden of proving that the conditions of a prohibited transaction exemption were satisfied falls on the person claiming the benefit of the exemption—in other words, on a broker-dealer or investment adviser that provides investment services to retirement accounts that result in prohibited transactions. For example, where a rollover recommendation is made, and the advisor will provide ongoing investment recommendations to the rollover IRA, the DOL will assert that the compensation earned from the IRA is a prohibited transaction, unless the conditions of PTE 2020-02 are satisfied. And the broker-dealer or investment has to be able to prove that the conditions were satisfied; the DOL doesn’t have to prove that they weren’t. As a result, the creation and retention of records is particularly important.
Recordkeeping Requirements
The PTE has two recordkeeping requirements—both for 6 years. The first one is a requirement that applies to all covered recommendations; the second applies to records reviewed as a part of the annual retrospective review.
The general requirement:
The Financial Institution maintains for a period of six years records demonstrating compliance with this exemption and makes such records available, to the extent permitted by law including 12 U.S.C. 484, to any authorized employee of the Department or the Department of the Treasury.
The annual review requirement:
The Financial Institution retains the report, certification, and supporting data for a period of six years and makes the report, certification, and supporting data available to the Department, within 10 business days of request, to the extent permitted by law including 12 U.S.C. 484.
At first blush, those requirements seem straightforward: Keep the records for 6 years. However, they are not. For example, the records to be retained are: “records demonstrating compliance” and “supporting data.”
The obvious question is, what records are those? For example, the PTE requires that a broker-dealer or investment adviser comply with the Impartial Conduct Standards when making a rollover recommendation. One of the Impartial Conduct Standards is the best interest standard of care, which is, in essence, a combination of ERISA’s prudent man rule and duty of loyalty. In the preamble to the PTE (and in FAQs issued by the DOL), the best interest standard requires that an advisor obtain information about the retirement plan’s investments, services and expenses. Is that information required to be retained for a period of 6 years? While the DOL doesn’t answer that question explicitly, it seems reasonable to assume that the plan information is a record “demonstrating compliance.” As a result, the safe answer is that plan information, and any other information required for the best interest process (and for compliance with the exemption more generally), should be retained in a retrievable format for at least 6 years.
Self-Correction Procedure
Recognizing that mistakes can be made and that they should be corrected, the DOL included a self-correction process in the PTE. That four-step procedure is:
Self-Correction. A non-exempt prohibited transaction will not occur due to a violation of the exemption’s conditions with respect to a transaction, provided:
(1) Either the violation did not result in investment losses to the Retirement Investor or the Financial Institution made the Retirement Investor whole for any resulting losses;
(2) The Financial Institution corrects the violation and notifies the Department of Labor of the violation and the correction via email to IIAWR@ dol.gov within 30 days of correction;
(3) The correction occurs no later than 90 days after the Financial Institution learned of the violation or reasonably should have learned of the violation; and
(4) The Financial Institution notifies the person(s) responsible for conducting the retrospective review during the applicable review cycle and the violation and correction is specifically set forth in the written report of the retrospective review required under subsection II(d)(2).
In advising clients about how to correct violations, the two most difficult requirements are to determine if any losses have occurred and to decide how to correct the violation.
In some cases, the determination of “loses” seems to be straightforward. If the rollover IRA was invested in good-quality mutual funds with reasonable expenses, and in appropriate allocations, there probably aren’t any losses. I say that for two reasons. The first is that it wouldn’t make sense for “loses” to refer to normal market fluctuations, even where the market goes down. The second is that, if the investments in the IRA went down, then the investments in the plan would have gone down in value as well. In other words, it just doesn’t make sense to say that there were loses under these circumstances.
However, it is possible that there could be losses in other circumstances. Since this requirement isn’t well defined, broker-dealers and investment advisers should seek the advice of knowledgeable ERISA attorneys to determine if there were loses and, if so, how to quantify them and how to restore them. As a practical matter, it will either take more guidance from the DOL or a few years of experience in working with the DOL before these requirements become clear.
With regard to the requirement to correct the failure, that refers to the “condition,” or requirement, in the PTE that wasn’t satisfied. For example, if the advisor failed to provide the retirement investor with the fiduciary acknowledgement, the correction should be to provide the acknowledgement. That seems straightforward.
But the correction of other failures can be more difficult. For example, if an advisor didn’t engage in a best interest process, and if the IRA investments are more expensive, how would the failure be corrected? The kneejerk reaction might be to put the money back in the retirement plan. But, in the real world, that won’t work. By then the retirement investor no longer works for the plan sponsor, and plans can’t and don’t allow transfers into the plans from former employees who no longer have accounts with the plans. That makes the correction difficult. An investment adviser might consider reducing or eliminating the adviser’s fees to the point that the IRA is not more expensive than the plan or might provide additional services so that the rollover IRA is superior to the plan. Broker-dealers might make similar adjustments. It’s not clear what works, but some steps will need to be taken so that the rollover IRA is in the best interest of the retirement investor. In my view, that kind of “fix” will be needed because there aren’t other practical corrections.
Each of the conditions in the PTE raises its own correction issues. As a result, corrections should be done thoughtfully and carefully.
Annual Retrospective Review
The PTE requires an annual retrospective review and report. The PTE says:
Retrospective Review.
(1) The Financial Institution conducts a retrospective review, at least annually, that is reasonably designed to assist the Financial Institution in detecting and preventing violations of, and achieving compliance with, the Impartial Conduct Standards and the policies and procedures governing compliance with the exemption.
(2) The methodology and results of the retrospective review are reduced to a written report that is provided to a Senior Executive Officer.
(3) A Senior Executive Officer of the Financial Institution certifies, annually, that:
(A) The officer has reviewed the report of the retrospective review;
(B) The Financial Institution has in place policies and procedures prudently designed to achieve compliance with the conditions of this exemption; and
(C) The Financial Institution has in place a prudent process to modify such policies and procedures as business, regulatory, and legislative changes and events dictate, and to test the effectiveness of such policies and procedures on a periodic basis, the timing and extent of which is reasonably designed to ensure continuing compliance with the conditions of this exemption.
(4) The review, report and certification are completed no later than six months following the end of the period covered by the review.
(5) The Financial Institution retains the report, certification, and supporting data for a period of six years and makes the report, certification, and supporting data available to the Department, within 10 business days of request, to the extent permitted by law including 12 U.S.C. 484.
Briefly summarized, the requirement is that the firm has to do an annual “audit” of the covered recommendations made in the prior year and reduce the review to a written report. Then a senior executive (most often the CCO) will need to certify the report, which will be available to the DOL upon request. I think it’s reasonable to assume that, in the next year or two, the DOL will begin investigations of broker-dealers and investment advisers for compliance with the conditions of the PTE and that the first request will be for the report.
However, the purpose of the certified report is not for investigations. Instead, it is to ensure that the financial institutions are complying with the conditions of the PTE and, to the extent that the review reveals deficiencies, those deficiencies are corrected, both retroactively and going forward. The reference to retroactive corrections is that, if the review discovers compliance failures, the financial institution should self-correct under the PTE’s correction procedures. The failure to correct means that the compensation resulting from the particular transaction (e.g., rollover) is a prohibited transaction. Since it would need to be included in the report as a compliance failure, it would be found easily by the DOL in an investigation.
While the DOL doesn’t spell out the details of its expectations for the scope of the review, it seems obvious that a sufficient number of randomly selected covered recommendations should be reviewed in order for the firm to determine if the PTE’s conditions are being satisfied across the full range of covered recommendations and by the advisors as a whole. The one helpful piece of guidance is in footnote 131 to the preamble to PTE 2020-02, which refers to FINRA rules 3110, 3120 and 3130.
Conclusion
While the conduct standards, disclosures and policies and procedures requirements of PTE 2020-02 are already applicable and financial institutions (such as investment advisers and broker-dealers) should be implementing those practices on a regular basis, the compliance job is not yet done. Compliance failures will be discovered through supervision and the annual review, and will need to be corrected and reported to the DOL. The requirement to maintain records supporting compliance will require extensive recordkeeping at a detailed level. And the annual retrospective review will require a review of covered recommendations of all types (including rollovers) that are made by a range of advisors so that the process is “reasonably designed” to ensure compliance with the exemption. If financial institutions do not have appropriate practices in place today, and/or if advisors are not implementing those practices properly, the annual review, and the resulting corrections, will be problematic.
Fred Reish is a Los Angeles-based Partner in the law firm Faegre Drinker. This article originally appeared in the Fall issue of NAPA Net the Magazine.
