Principal Trading
Art by Tim Bower
As I wrote in this column four years ago, advisers, when engaging in principal transactions with their clients have specific compliance obligations under securities laws, the Employee Retirement Income Security Act and the Internal Revenue Code. In the case of such transactions involving ERISA-covered accounts and accounts subject to the prohibited transaction provisions of IRC Section 4975—e.g., individual retirement accounts—the adviser must rely on a prohibited transaction exemption. Doing so has become more complicated, with the Department of Labor’s issuance of Prohibited Transaction Exemption 2020-02 and its interpretation of “investment advice.”
Advisers, particularly broker/dealers that maintain non-advisory brokerage accounts, have always sold securities on a principal basis to ERISA-covered accounts and IRAs. PTE 75-1 provides exemptive relief in the event the adviser does not act as a fiduciary. However, many advisers that provide recommendations to buy or sell securities in brokerage accounts that are non-advisory for purposes of the Investment Advisers Act or comparable state law are of the view that they provide investment advice for purposes of ERISA or the IRC. Thus, they must comply with PTE 20-02; however, this applies with transactions involving only certain situations and certain securities.
The DOL states that a principal transaction is “a purchase from, or sale to, a Plan or an IRA, of an investment, on behalf of the financial institution’s own account or the account of a person directly or indirectly, through one or more intermediaries, controlling, controlled by, or under common control with the Financial Institution.” However, a principal transaction does not include the sale of mutual funds or insurance products such as annuities.
So long as the adviser meets the conditions of PTE 20-02, he may recommend that a client engage in a “riskless principal” transaction. There’s no limit as to the type of security that may be recommended. The DOL states that a riskless principal transaction is “a transaction in which a financial institution, after having received an order from a retirement investor to buy or sell an investment product, purchases or sells the same product for the financial institution’s own account to offset the contemporaneous transaction with the retirement investor.” The DOL provides no more information about when a transaction is a “riskless principal” one. How it is booked under federal security laws may carry weight.
The DOL provides no more information about when a transaction is a “riskless principal” one.
If the transaction is not riskless, PTE 20-02 requires that it fall within the definition of a “covered principal transaction.” If the adviser is buying the security from the ERISA-covered account or IRA, a covered principal transaction includes both equity and debt securities. In the case of a sale, though, the transaction may involve only certain securities: U.S. dollar denominated corporate debt securities offered pursuant to a registration statement under the Securities Act of 1933; U.S. Treasury securities; debt securities issued or guaranteed by a U.S. federal government agency other than the Department of Treasury; debt securities issued or guaranteed by a government-sponsored enterprise; municipal securities; certificates of deposit; and interests in certain unit investment trusts.
This is a relatively narrow group of securities. The exemption does not allow for the sale of equity, foreign debt and myriad other securities that firms traditionally sell on a principal basis. Certain hybrid securities such as equity-linked notes or asset-backed securities that have substantial debt and equity features may not neatly fit within the definition. Also, PTE 20-02 requires that, with respect to debt securities, the adviser must have written policies and procedures that are reasonably designed to ensure that the security, at the time of the recommendation, has no greater than moderate credit risk and sufficient liquidity that it could be sold at or near carrying value within a reasonably short period of time.
Advisers who sell securities on a principal basis to ERISA-covered accounts and IRAs, and also provide advice, need to comply with PTE 20-02. Unless the transaction is conducted on a riskless principal basis, there could be substantial restrictions on the type of security sold. Compliance with PTE 20-02 requires the application of other conditions such as the recommendation being in the best interest of the investor despite conflicts of interest, which, in the DOL view, are substantial. If the security involves an extension of credit, compliance with another exemption may be necessary.
David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C.