Don't Forget About Sweep Programs
Prohibited transactions under the new fiduciary rule
Reported by David Kaleda
Art by Tim BowerA sweep program, fund or similar device is a common means
used by retirement plan advisers and their affiliates to hold account assets on
a short-term basis pending an investment or other transaction. These programs
may give rise to prohibited transaction issues under the Internal Revenue Code
(IRC) or the Employee Retirement Income Security Act (ERISA), particularly when
the adviser acts as a fiduciary. Therefore, in light of the fact that many
advisers will become fiduciaries on April 10, 2017, pursuant to the Department
of Labor (DOL)’s final investment advice regulation, it is important that
advisers can recognize and address these issues.Both ERISA’s and the IRC’s prohibited transaction provisions prohibit an adviser from using his role as a fiduciary, either through providing investment advice or acting as a discretionary manager, to deal with plan or individual retirement account (IRA) assets in his own interest or for his own account—i.e., no self-dealing. Additionally, a fiduciary may receive no consideration for his own personal account from any party dealing with plan or IRA asset accounts in connection with a transaction involving their assets—i.e., no kickbacks. These prohibitions apply to ERISA-governed plans and IRAs.
Prohibited transactions arise in connection with sweep programs. If, because of an adviser’s investment advice, amounts held in an account are swept into an investment option that pays him, his firm or an affiliate a fee or some other consideration, a prohibited transaction results. For example, the investment option may be advised by an affiliate or may be a deposit account at an affiliated bank. The financial benefit realized by the affiliate results in a prohibited transaction. Additionally, even if not affiliated, the investment option or the provider of the option may pay the adviser, his firm or an affiliate for investments in the option, which also is prohibited.
The DOL takes the position that a fiduciary’s ability to control the amount and timing of his or an affiliate’s compensation is a prohibited transaction. The investor’s approval of the sweep vehicle does not eliminate the amount and timing problem. Similarly, a prohibited transaction may result under a discretionary management program. If the adviser, his firm or an affiliate decides to invest plan and IRA assets in the sweep option and realizes a financial benefit therefrom, a prohibited transaction occurs.
Notably, the application of the prohibited transaction rules in the context of sweep programs is not a new issue. However, the frequency with which these issues arise will increase significantly next April when FINRA’s definition of “investment advice” will become subject to a suitability standard. In such circumstances, the adviser, and possibly his firm, will be acting as fiduciaries, while currently this is not the case. Therefore, advisers and firms will need to address these uses under traditional brokerage accounts connected to plans and IRAs just as they currently should be doing for plans or IRAs in advisory or discretionary management programs.
In the face of a prohibited transaction, the fiduciary should comply with the pertinent exemptions. Currently, fiduciaries look to Prohibited Transaction Class Exemption 77-4 to release them from liability for such transactions that arise in connection with mutual funds advised by an affiliate, and to the statutory exemptions under ERISA Section 408(b)(4) and IRC Section 4975(d)(4) for bank deposits at affiliated and unaffiliated banks.
These exemptions will continue to be available next April. In addition, at that time, the adviser and his firm may consider relying upon the best interest contract (BIC) exemption. However, that will be available only in connection with providing investment advice, not providing discretionary account management. Other exemptions or conflict mitigation strategies should be considered.
As firms analyze how the final regulation applies to them and develop compliance strategies, they should keep in mind how they and their advisers use sweep accounts. Almost certainly, changes are necessary to meet the requirements of available exemptions. Otherwise, advisers and firms may be subject to ERISA fiduciary liability, excise taxes under the IRC, and state law claims.
David Kaleda is a principal in the Fiduciary Responsibility practice group at the Groom Law Group in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers. He served on the DOL’s ERISA Advisory Council from 2012 through 2014.