Do Not Trust Your Compliance Consultant’s Legal Advice

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 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.