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Regulation and Compliance > Federal Regulation

Do Not Trust Your Compliance Consultant’s Legal Advice

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This article is supposed to serve two purposes: (1) to argue that it is reasonable for an investment adviser in most instances to receive investment advisory fees from rendering investment advice to their family member’s individual retirement account (“IRA”), and (2) to make you second guess the advice you receive from your compliance consultant.

Be wary before you trust a compliance consultant who is providing you advice on complex legal issues, such as ERISA or the Internal Revenue Code (the “Code”). While many compliance consultants add value, you must understand their limitations. One of those limitations is that they do not have years of highly relevant legal education that focuses on reading a statute, analyzing regulations and seeking out interpretive guidance.

I came across a perfect example of a compliance consultant making an egregious mistake the other day. A prospective client received a mass email from their consultant that identified a potentially problematic business practice for them. They brought it to our attention for a second impression. The email stated:

We wanted to bring to your attention an IRS regulation that impacts IRA accounts. It relates to ensuring compliance with [the Code] Section 4975 and related Internal Revenue Service (IRS) self-dealing and prohibited transaction considerations. Under IRC Section 4975, certain family members of a Retirement Account holder are deemed “Disqualified Persons.” Disqualified Persons may not engage in acts of self-dealing. Self-dealing considerations are implicated where certain family members are hired as Advisors and receive compensation from a family member’s Retirement Account. As such, if an Adviser is receiving compensation from a family member to manage the family members’ IRA account, it is a prohibited transaction. Unless an exemption applies, the IRS has enforcement authority which can range from assessing a 15% excise penalty to disqualifying the IRA.

As a result of this rule, we encourage you to review your existing accounts and ensure the firm is not being compensated for management of family members’ IRAs. This IRS regulation is not currently included in your Compliance Policies and Procedures Manual and we are taking the approach that it is optional. If you wish to include the information in your compliance manual, please let us know.

This communication showed that the compliance consultant identified a law, analyzed it and concluded that a certain practice was in violation of the law, and implicitly that there was no relevant exemption for this practice. The consultant’s advised that the prospective client must forego revenues, because the consultant believed that providing services to a family member was a non-exempt prohibited transaction under the Section 4975 of the Code. This appeared wrong to me on so many levels.

Interpreting the Code isn’t an easy task—the Code is a labyrinth.  Also, this area of the Code is especially complicated as it has a unique interplay with the Employee Retirement Income Security Act of 1974—otherwise known as ERISA.  Reading the relevant paragraphs of Section 4975 would have only been the first step of this exercise.  However, there are also regulations that accompany the Code.  Then there is a unique industry understanding that can only be held by a person uniquely familiar with ERISA.  This consultant clearly did not have a clear grasp of the regulations or the industry experience to opine on this issue.

Second, the consultant could have been found to have been involved in the unauthorized practice of law or accounting. I won’t touch on this issue, because it is beyond the scope of this article.

Lastly, this consultant didn’t even put the ball in play. The only part of the analysis that they got right was the plain meaning of Section 4975(c) of the Code, which was that the furnishing of services between an IRA and a disqualified person is a prohibited transaction in the first instance. However, their analysis completely ignored the following paragraph, Section 4975(d), which exempts any “reasonable arrangement, made with a disqualified person for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan [or IRA], if no more than reasonable compensation is paid therefor.” The regulations under the Code define a service as “necessary” where it is “appropriate and helpful to the [IRA holder] obtaining the service in carrying out the purposes for which the [IRA] is established or maintained.”

It would be reasonable to conclude that the provision of investment advice by a registered investment adviser to an IRA would be appropriate and helpful to the IRA holder. If there was any doubt remaining whether this was “necessary”, a practitioner could review comparable provisions found in ERISA that would permit this practice (i.e., the 408b-2 regulation).  The only remaining question left is whether the compensation paid by the IRA holder is reasonable.  There is plenty of guidance under the Code and ERISA in determining whether compensation is reasonable.

While certain people point to Section 4975(f)(6) of the Code for the proposition that investment advisers cannot rely on Section 4975(d) in servicing their family members’ IRAs, that section by its plain meaning, applies only to “a trust described in section 401(a) which is part of a plan providing contributions or benefits for employees.” Traditional IRAs are not typically held in trust, and they are not part of a plan for employees. Further, they are not described in section 401(a).

In short, as long as the investment adviser was not using its “authority, control, or responsibility which makes such person a fiduciary to cause a[n] [IRA owner] to pay an additional fee”, then this type of activity would likely be a permissible.  To be put another way, it would be an exempt prohibited transaction.

As discussed previously, ERISA and the Code are complex areas, and readers should not assume that this is a complete analysis of all the prohibited transactions presented by this fact pattern, and should not rely on this discussion as legal advice. Readers are encouraged to seek out legal counsel.

Max Schatzow of Stark & Stark (Photo: Stark & Stark)Max Schatzow is an Associate at Stark & Stark and a member of its Investment Management & Securities Group, where he concentrates his practice on counseling financial service entities including investment advisers, broker-dealers and private investment companies on registration, compliance, liability and litigation issues. Max’s practice also focuses on the formation of private investment funds. He advises fund managers with respect to day-to-day legal, fund maintenance and operational matters, including internal general partner and management company issues.