DOL PTE 2020-02 - What Comes Next

In February, a US District Court judge challenged the DOL’s FAQs around the fiduciary investment advice definition to rollover recommendations. In today's episode, Part 2 of 2 discussing DOL PTE 2020-02, experts Fred Reish, David Porteous and Joan Neri from the law firm of Faegre Drinker Biddle & Reath join Oyster's Ed Wegener  will be discussing this case and other legal challenges, and the impacts these will have, if any. 

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Transcript

Bob Mooney:  Welcome to the Oyster Stew Podcast. I'm Bob Mooney, General Counsel for Oyster Consulting. Thanks for joining us for the second of two podcasts covering the current state of the DOL PTE 2020-02.   Oyster’s Ed Wagner continues his discussion with DOL PT experts, Fred Reish, David Porteous, and Joan Neri from the law firm of Faegre Drinker Biddle & Reath. In February, a US district court judge challenged the DOL's  FAQs around the fiduciary investment advice definition to roll over recommendations. Today, our experts will be discussing this case and other legal challenges and the impacts these will have, if any. Let's pick up where we left off.

Ed Wegener:  Taking this back to where we are currently, this has been a very long and winding road, going back to the best interest contract exemption and along that long and winding road, there oftentimes are court challenges to the rules. And there was a court challenge specifically around the application of the PTE two rollover recommendations and the guidance that was in the FAQs. Can you talk about the court challenge, the results of the court challenge, the impact and where things stand right now?

Joan Neri:  Yeah, I'll kick it off and then I'll turn it over to Fred and David. But yeah, this was a lawsuit brought by the American Securities Association. It was a federal district court that weighed in on this. And as you said, it was specific to rollover recommendations.  There was a lot of confusion by many of my clients than they thought that there was a broader impact here. But what the plaintiff focused on in this case was two elements of the guidance that the Department of Labor issued in the form of frequently asked questions in connection with the PT 2020- 02. And those two questions, I'll dispose of the first one. First the easier one because here the court agreed that this guidance was appropriate. And the challenge had to do with the application of the best interest process in carrying out the standard that the PTE requires.

And as you said, in particular with respect to rollovers, and this guidance talks about the fact that the best interest process should include an evaluation of the plan or the IRA that the investor is in, and the rollover IRA. And that comparison should look at the very least, the services, the fees, and the investments, and then all other relevant factors associated with the two accounts. And then ultimately the advisor needs to determine what is in the best interest. And the court said that's a perfectly appropriate prudent process for undertaking the standard that the PTE requires. The bigger issue has to do with the guidance. The FAQ that had to do with the Department of Labor's reinterpretation of regularly provided, which I talked about earlier.

And here the court ultimately determined that interpretation was arbitrary and capricious and should be thrown out.  What the court said was that five-part test, which Fred referred to again refers to the plan that the investor is in. So when you're looking at the regularly provided element, you were supposed to be looking at the plan, not at the IRA that the rollover will end up in and therefore a rollover recommendation where an advisor has no preexisting relationship and is just anticipating a relationship, a financial relationship in the rollover IRA. Well, that's not going to meet regularly provided. So that was the end result of this court decision. And that left many thinking that they were off the hook with rollover recommendations. But that's not entirely true for a number of reasons.

First of all if this court decision were to stand there is guidance the Department of Labor issued back in 2005 on whether a rollover is fiduciary advice. And under that guidance, the Department of Labor drew a distinction between an advisor who has a fiduciary relationship with the plan and one who doesn't. And in the case of an advisor that's already a fiduciary to the plan and then makes a rollover recommendation to a plan participant, well, that is considered fiduciary advice under the 2005 guidance. And so that certainly wouldn't change. And then also as we mentioned earlier, this court decision only had to do with rollover recommendations, not other non-discretionary advice that an advisor may be using the PTE relief for. And the latest news is a notice of appeal in connection with this. So, Fred, let me kick that off to you and you could give a little bit more information on the status of that.

Fred Reish:  Sure. the DOL has just filed a notice of appeal of the Florida District Court decision which effectively, in my mind at least, puts everything up in the air.  Because if people say, I'm going to rely on the Florida District Court decision and stop following PTE 2020-02, because I'm no longer a fiduciary for rollover recommendations.  Therefore, since I'm not a fiduciary, I don't need the PTE.  They're at risk because if the court of appeals then reverses it, they've got a year or more of non-compliant rollover recommendations that they're not entitled to their compensation on. The broker dealer isn't entitled, the investment advisory firm isn't entitled, and the individual advisors aren't entitled. So plus interest plus penalties, in other words, they’re no-win situations. So the effect is that rollover recommendations are now in a state of limbo. We don't know what to do.

We only know that the only safe answer is to continue to comply with PTE 2020-02, satisfy the conditions, and just hold on and wait. I would also point out, as Joan did, we've really got to talk about PTE 2020-02 in three categories. One is ongoing advice to retirement plans. If you have ongoing advice to retirement plans and you have a prived transaction, for example, you're fiduciary, that makes you a non-discretionary fiduciary to the plan, because every year you're making recommendations by sell or hold the investments in the plan, explicit or implied recommendations, you're a fiduciary. And if you're getting commissions or revenue sharing of some kind, some compensation on it, that's a prohibited transaction and you need 2020-02. Same thing for IRAs, where you're more likely to find ongoing advice with commissions and other compensation coming from third parties prohibited transactions.

You need PT 2012. Those two plans and IRAs are not what the court cases were about. That seems to be set in stone. Now, you need PTE 2020-02 if you satisfy the five part test. So we're only talking about rollover recommendations. So when I say because of the notice of appeal, things are in limbo, I'm talking about rollover recommendations, there is no limbo for advice to plans and advice to IRAs. So there, we don't know what the court of appeals is going to decide. We don't know if it might be an appeal to the Supreme Court which could mean three years from now we're still waiting for an answer. We're just going to go into a phase where the safe answer, the conservative answer is continue to comply, satisfy the conditions of PTE 2020-02 so that no matter what the outcome of the court decision is, you're on solid ground legal ground. So that's where I think we are. And I don't see an alternative. I mean, people could take risk and say, okay, I'm not going to comply, but gee, who wants to expose themselves to hundreds or thousands of prohibited transactions?

Ed Wegener:  Well, also, you’ve got to consider the SEC requirements too, around rollovers, which definitely cover rollovers, whether that's Reg BI or the fiduciary requirements for investment advisors.  So trying to parse that out would be really challenging.

Fred Reish:  Yeah, I agree. And, I regret not mentioning that. I'm glad you did. If folks look back to the SEC staff bulletin on standard of care from last year, from 2022, I think they'll find it remarkable how much the SEC position parallels the DOL position. You don't have to have the specific reasons in writing why the rollers in the best interest. That's not an SEC position, although they do say that you might want to document things and there's no private right of action as there is with ERISA. But everything else is the same. You’ve got to look at the plan, the way Joan described it, the investment services expenses in the plan. You’ve got to look at the IRA, you’ve got to do a comparative analysis. You have to decide what's in the best interest of the investor. That's the same for DOL, SEC for broker dealers and SEC for investment advisors.

Ed Wegener:   In reading that bulletin, it really seemed like the language was very intentional.

Fred Reish:  <Laugh>, You almost get the idea they're talking to each other, don't you, <laugh>?

Ed Wegener:  Absolutely. Well, one of the things that you mentioned, and, because we're in mid-April and June is fast approaching, that's going to be important for firms to do in complying with the requirements, is this retrospective review requirement. And I do want to turn to that, and it's one of the areas that we've been interacting with our clients, probably most often of late, in terms of the requirements around the DOL. And so we've been engaging with clients to do testing of their program in the lead up to this June requirement date. And, Dave, I'll talk about what we've been looking for in terms of the testing and the approach that we've been taking, but I'd like to get your thoughts. Because I know that you do a lot of guidance with your clients with respect to testing, whether it's broker dealers or investment advisors, and now with this retrospective review.

But the approach that we've taken is very similar to the approach that we take in other types of testing. We first focus on making sure that the firm has well-written and appropriate policies and procedures, then testing to make sure that those procedures are being effectively implemented, and then any certifications that are required, making sure that that's done. And so with respect to that approach, what we've been looking for is assessing the policies and procedures and make sure that they covered all of those elements that Joan talked about. Whether it's the impartial conduct standards, the requirements for disclosures, everything that's required, making sure that the firm has adequate procedures, making sure that any assumptions that are in the procedures regarding the applicability of the exemption, like we talked about no recommendations or education only making sure that those assumptions are correct and that they're supported and documented.

Making sure that there's effective training of the firm's policies and procedures, so the people who are in the field understand what the requirements are when utilizing the exemption and then starting the testing, testing can make sure that things are implemented effectively, making sure disclosures are made and made on time, making sure testing to make sure recommendations are in the customer's best interest. Assessing rollover recommendations, making sure that those assessments are done and that they're adequately documented and the disclosures are made. And importantly, making sure that communications aren't misleading. Testing compensation, making sure that it's reasonable, and then creating that draft report so that it can be reviewed by the firm. And then ultimately certified by the appropriate member of senior management. So that's the approach that we've been taking with firms. As we get closer and closer to June, we anticipate we'll probably be doing a lot more of these, but my advice would be to try to start early, because I think especially with this first round there's going to be a lot of questions that come up as part of this process and make sure that you leave yourself enough time to address any of those questions in advance of the deadline.

Ed Wegener:  David, in, in terms of your experience with broker-dealers, investment advisors, other clients, what are some of the effective practices you've seen with testing and what are some of the questions that you get?

David Porteous:  Yeah, I'd say the biggest question really is how much is enough? And this is ultimately a numbers game. And what I see is a divergence of practice between firms for which you have a small sales force, for lack of a better term, in terms of IRS or registered reps or both. And, and if the ratio of the salesforce to, let's say supervisory and or compliance personnel is manageable, the number of transactions given to your client base is manageable. If given all of the implementation you described to the front end, adequate policies and procedures, good training, good documentation practices, that type of hygiene, then it's going to make it a bit easier to say, look, we're not going to screen and supervise every transaction on a pre-transaction closing basis, meaning recommendation occurs, paperwork is created, and then it's passed to what in the brokerage world, we call a supervising principle for review, pre-closing of the transaction.

Instead, you're going to say, look, we'll allow the people the freedom, given all of the training and the paperwork that we put into this and the adequacy of our procedures, we're going to rely upon that system, and we're not going to review every transaction by transaction on the front end. We're going to rely upon a system post-transaction of testing, and it's all a numbers game in terms of that quantitatively.  I've heard some firms saying, we're requiring documentation for every transaction. We're not going education only, and we're going to pre-review every transaction prior to its closing by a supervising principal. At least put eyeballs on it as compared to circumstances in which that's just not feasible given human capital. We just don't have enough people. And the number of transactions who might be reviewing and recommending on a daily basis is too voluminous for us to put eyeballs on every transaction.

So we're going to rely upon a system of testing after the fact. Okay, fair enough. Then if that quantity is, that substantial, then this quality of your testing practices is going to have to be risk tuned, right? You know, what are particular types of transactions that we're going to be more focused upon? A certain type of client base, a certain type of it's a complete rollover from a plan to an IRA compared to an IRA given our documentation, where have we had a bit more issues where there were some questions and devising a testing process that is ultimately risk-based such that you can defend it after the fact. But I think leading to a 12 month annual retrospective, what the best practices I've seen borrowed from the brokerage world is at a minimum you're doing a 90 day retrospective review on a risk basis, as we just discussed, some statistically significant sample.

You know that's going to vary from firm to firm. I can't give you a specific number, but you can certainly use a percentage model and then make it very risk focused.  We targeted this bucket, but we're doing it every 90 days. So then that way at the end of the 12 month period, you're having the conversation much as happens in the broker dealer world to say, our annual certification is predicated upon four quarters of testing, and here's the output we got as a consequence of each of those quarters of testing. And as we had certain deficiencies or corrections that we needed to make, what did we do in response? So that those numbers hopefully ebbed down, heading into the first annual retrospective review as compared to saying, it didn't go so great - First quarter got even worse, second quarter man, third quarter just blew up.

And it's like, what are you doing in response to the data that you're getting? Because if you're testing is giving you an output that says somebody's not understanding something, the quality of the recommendations and the new number of times we're going to have to make a correction here are pretty high. That is the type of information you want to have at the end of the one year period to be able to say, we did the testing quarterly so that we could gauge how well we're doing and implement refreshers inside each of the 90 day periods after that test in order to figure out how well we're doing. I'll just say on a calendar, what I've seen typically, broker dealer or dual IABD testing usually is, they started about 30 to 60 days out from the end of the previous quarter so that it's the 90th day. They have an analysis of what's been happening in the previous 30 to 60. So it's not just waiting until 90 days and then we're at 120, 150 to even find out how well we did. So it's really being a bit rigid with the calendar and then trying to slice off a percentage.

Ed Wegener:  Those are all really important points. And, you know, one of the things I would say is and this is anytime you're doing testing, is that the annual testing is not a replacement for regular monitoring. You should be doing regular monitoring and making sure that you're identifying issues and as you said, addressing those when those things come up. I think that that's really critical distinction to make sure that you understand is not set it, forget it, and then do the annual testing. And we're going to talk about self-correction later, and this kind of gets into that and the timing around that. The other thing though, I used to have this question a lot when I worked at FINRA and we'd send examiners out to do examinations, and it was the same question, like when we're talking about testing what's enough, and you have to really look at what's the purpose of the testing is you want to come away from that testing, feeling reasonably confident that you don't have major issues.

So the testing when it comes to the numbers and how much is enough testing, it's at that point where you feel comfortable that your process is working and that you're identifying any issues that need to be addressed. So in terms of the representative sample, just like you said, that number's going to vary depending on a lot of factors, but you want to make sure that it's enough where you're getting a good representation of the transactions that are subject to these requirements. And then the risk faced portion of that too is in addition to just doing a random representative sample, you also want to understand, well, where are the risks that we're probably more likely to have issues and make sure that you're doing testing in those areas just to make sure that you're comfortable in those areas.

And what you really want to do is come away with a reporter saying, we've identified the things that need to be addressed. We have a plan to fix those issues. And that you're giving the person who's signing off on that certification a comfort level that they feel comfortable in providing that certification. So it'll be interesting.   I think the first round of testing on this, they're probably found a number of issues that need to be addressed as firms address those, I think subsequent years will probably go a lot smoother.  But I also think that as we go through this, a lot of interpretive questions will come up that you need to reach out to your counsel like the three of you to say, hey, we've got this question that's come up as part of our testing, how should we address that? I do want to end on, the question with respect to self-correction. So, and it follows on, you're doing regular monitoring, you're doing retrospective, annual retrospective reviews, you find issues where you may not have been a hundred percent compliant. What's the next step and what is the DOL expecting in terms of what to do in those situations and when is self-correction required?

Fred Reish:  Yeah, Ed, let me jump in on this one. I mean, the basic answer is simple. You're supposed to fix it and you're supposed to report yourself to the Department of Labor. There's a whole process in PTE 2020-02 that gives you the timeline for doing that. But there is a process and there is a site with an email address where you would send your report.  I would say in doing that, in notifying the Department of Labor of the error and the correction, I would make a big point of pointing out all the steps you've taken to generally be in compliance, because it's important that the department understand that this was an exception. This is something that happened notwithstanding your training, your policies, and procedures and all the things, all the forms, everything you've done along the way they're going to look at it differently if they think that this indicates a lack of seriousness as opposed to whether they indicate whether they think what you're reporting is an accident that happened even though you've made a really serious effort to comply.

So that's sort of lesson number one. And you don't get the relief if you don't self-report, period. Now how do you correct. That's really the big issue. If you think about it, you can't put the money back on the plan once a participant has left a plan. You can't roll money back into a plan where they don't work anymore, and they don't have an account balance on the plan anymore. So you're sort of stuck. The errors that I've consulted with clients on vary from, I failed to give the fiduciary acknowledgement. One client I helped failed to give the fiduciary acknowledgement about in about a hundred cases to a lot, but it was a computer glitch and they fixed it, and their base of recommendations is in the thousands. So it wasn't quite as big as it sounded like at first.

There's no guidance on how to correct. The client ended up deciding to go and distribute the fiduciary acknowledgements to all of those people. Nobody objected. So they didn't have to deal with the second half of the issue which is, what if somebody had objected because they didn't get it on a timely basis. But in that case, it seems like for the disclosure documents, one approach would be to then hand out the disclosures. The difficulty is what happens if they object? The DOL has not spoken out on that. If they take a really hard line, they could say, even if somebody doesn't object, you got to put them in at least as good a position as they would've been in the plan, which probably means dramatically reducing the expenses of their investments. But I'm not saying you have to go that far, I'm just saying that's the worst case scenario.

Another example is what happens if the investments in the IRA weren't in the best interest of the participant, never mind the role of a recommendation? But we see that, well forget an IRA. Think about a retirement plan where the mutual fund prospectus says, we'll waive front end loads for retirement plans, and it wasn't waived. That would be an example of where a mistake can be made inside the IRA, that would already be a mistake under the securities laws, but it would also be fiduciary breach here. And then you correct that by getting it back to where it should have been. You’ve got to fix it. And then the third thing is, what if the advisor just did not engage in a best interest process to recommend the rollover, or they did, but they failed to look at the appropriate things or they did, and it just wasn't in the best interest,  but they made the recommendation anyway.

In that case, that's really hard because let's say it was from a very large plan, and the average expense ratio of all the investments in the plan was 15 basis points, which is not inaccurate for the mega plans. Well, the only thing I think you can do at that point, since you can't put it back in the plan, is reduce their expenses to 15 basis points. Because I think you have to go back and rejigger how they're invested so that you make the IRA in their best interest, because I don't see any other alternative other than doing that. And then people say, well, how long do we have to do that for? Well, they could have stayed in the plan pretty much forever, so forever.  And we have no guidance, in effect, we're making up answers as we go.

The one thing I would say about this supervision and the retrospective review in this context though, is that if you're immediately supervising recommendations and you catch that on day one, a bad recommendation is made and it is fixable and you fix it on day one, you've got at least an argument that passes the laugh test that, wait a second, this is a dual responsibility the best interest process. It's a combined advisor and broker dealer, or RIA entity combined individual and entity recommendation. And we fixed it. It's got to go through both filters, both the advisor filter and the entity filter before it is a prohibited transaction. And we fixed it before it went through the entity filter, therefore it was never a prohibited transaction. I've got some clients that are going to take that approach where they catch it very early and so that they're not identifying it in the retrospective review a year later.

I will say it's not clear that that approach works, but folks are really reluctant to report themselves to the government. And the difference there is they fixed it, and they're not reporting themselves to the government. So that then gets you to the last thing I wanted to say, which is, some clients have said to me, well, Fred, we're not going to self-report our really little violations. I'm sure it comes as no surprise to you, Ed, or to John or to David, that there's no such thing as a little violation <laugh>, it's nowhere in the PTE or the word, there's the word little up there. It's either a violation or it's not. And if you want it corrected, fully corrected such that you can't be second guessed by the Department of Labor, then you've got to report it through that process that I described earlier. So that's where we're going. I mean, we're sort of feeling our way on this one because there's no guidance on what self-correction means. The most obvious, putting the money back in the plan, simply isn't available. So you sort of have to make it up inside the IRA when it's a rollover recommendation.

Ed Wegener:  I think all the more reason to make sure that you have a really good set of policies and procedures and monitoring efforts to make sure that you're catching these things right away and being able to take corrective action as soon as possible. And then if there's any question to reach out to your counsel and talk about what needs to be done.  Well, this has been a fascinating discussion. I really appreciate all of your points and the discussion, Joan, Fred, and David.  I'm sure there's going to be more to come, and I look forward to having future conversations in the near future.

Fred Reish:  Thank you, Ed.

Joan Neri:  Thank you, Ed. Take care. Bye

David Porteous:  Bye-Bye everybody.