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.”

Financial institutions’ policies and procedures must also include supervisory oversight of investment recommendations…and provide for increased monitoring of recommendations at or near compensation thresholds, recommendations at key liquidity events for investors such as rollovers, and recommendations of investments that are particularly prone to conflicts of interest, such as proprietary products and principal-traded assets.

One approach is for financial institutions to design their reward programs with smaller incremental steps for qualification for rewards and with more limited benefits for reaching each of those incremental steps–and then to have enhanced supervision as the investment professionals approach the incremental qualifying levels, Reish suggested.

“Relatively minor payments or benefits would be less likely to incent a recommendation that is not in the best interest of a retirement investor and, as a result, the mitigation efforts need not be as demanding,” Reish said. 

There are, however, conflicts that cannot be mitigated by levelizing compensation or reducing the differences in compensation, he said. One example is a plan-to-IRA rollover recommendation. If the retirement investor accepts the recommendation, the firm and the investment professional will be compensated from the rollover IRA, but if the retirement investor does not, the firm and the investment professional will not make any money, he said.

In these cases, “the first line of ‘defense’ is to have a well-defined and documented process for evaluating the relevant information and making an informed and reasoned decision in the best interest of the retirement investor. Then those recommendations could be subject to heightened supervision,” Reish suggested.

While there is little direct guidance on how to mitigate these “all or nothing” recommendations, “it seems likely that the strength of the process (including the information reviewed and considered as a part of that process) and the degree of supervision will be important elements of mitigation,” he said.