Broker-dealers and registered investment advisors should prepare for regulatory exams next year that focus on how they eliminate or mitigate their compensation conflicts, according to Fred Reish, a partner at Faegre Drinker who specializes in fiduciary practices.

Because the Department of Labor and the Securities and Exchange Commission enforce investment advice regulations that leave much to interpretation, those that aren’t prepared with compliant compensation programs are likely to be subject to “regulation by examination,” Reish warned in his latest blog.

Regulators’ views on conflict elimination and mitigation “may differ from the private sector’s in the sense that they may expect more than is anticipated,” Reish said. “To avoid that outcome, financial institutions should consider using conservative conflict elimination and mitigation practices.”

The DOL, for example, allows firms and their reps to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to retirement plan and IRA investors. At the same time, however, the agency greatly expanded its definition of fiduciary advice, meaning that many more financial institutions and professionals will be considered fiduciaries for their recommendations to retirement investors and will need the protection provided by the exemption.

One of the mandates for the exemption is the mitigation of conflicts of interest.

In contrast, Reg BI requires mitigation of conflicts, but does not provide any guidance about the degree of mitigation that is required, he said. In contrast, PTE 2020-02 seems to require that the mitigation reasonably eliminates the incentive for the firm and the retirement professional to place their interests ahead of the retirement investor.

“If literally applied, it would be hard to satisfy that standard, since transaction-based compensation acts as an incentive. As a result, it remains to be seen if the PTE will be enforced in a manner that requires more stringent mitigation practices than Reg BI does,” Reish said.

Regulators have warned that financial institutions need to avoid using quotas, bonuses, prizes or performance standards as incentives that could lead to investment advice that is not in clients' best interest.

“The greater the value of the award, the more likely it is to incent recommendations that favor the investment professional, even if not in the best interest of the retirement investor, and therefore more difficult to mitigate,” Reish said.

According to the DOL, “As much as possible, firms should carefully design differences in compensation between categories to avoid incentives that place the interest of the firm or investment professional ahead of the financial interests of the customer.”

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