The SEC Is Watching

Art by Tim BowerAdvisers who are registered under the Investment Advisers Act of 1940 are well aware of the conflict of interest provisions found in the act and the corresponding procedures required by Securities and Exchange Commission (SEC) regulations and guidance. When those same advisers act as fiduciaries to plans governed by the Employee Retirement Income Security Act of 1974 (ERISA), or to individual retirement accounts (IRAs) or other arrangements subject to the prohibited transaction (PT) provisions of the Internal Revenue Code of 1986 (IRC), they are subject to separate conflict of interest provisions under that code and ERISA.

Advisers should not assume that the measures they take to resolve conflicts under the Advisers Act will be effective under ERISA and the IRC. There are substantial differences among the conflict mitigation requirements of those three enactments. The differences will be of even greater significance once the Department of Labor (DOL) publishes its final “investment advice” regulation, expected to be at some point this year.

The SEC and the courts interpret the Advisers Act as imposing a fiduciary duty on advisers. Accordingly, an adviser may not put himself into a position where his own interests may come into conflict with those of his client.

In many situations, the courts and the SEC take the position that an adviser can fulfill his duties under the Advisers Act by adequately informing a client of a conflict and receiving the client’s informed consent. Of course, many advisers take additional steps to mitigate conflicts. For instance, an adviser may be “walled off” from other professionals in the organization, so that he is less likely to be put in a position where he will fail to act in his client’s best interests.

On the other hand, ERISA imposes on fiduciaries—among other duties—duties of prudence and loyalty. Layered on those are prohibited transaction provisions. Pursuant to ERISA Section 406(a), a fiduciary is barred from causing the plan to enter into transactions with “parties in interest” in the absence of a PT exemption. These transactions are called the “per se” prohibited transactions because one results regardless of the fiduciary’s motive for entering into the prohibited transaction.

Additionally, a fiduciary may not, in the absence of an exemption: 1) deal with assets of the plan in his own interest for his own account—i.e., no self-dealing; 2) act in any transaction involving the plan on behalf of a party whose interests are adverse to the interests of the plan—i.e., no conflicts of interest; or 3) receive any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving plan assets—i.e., no kickbacks. Generally, these are not per se prohibitions as described above, but at least one court does not agree.

The IRC does not impose fiduciary duties on advisers. However, it does prohibit a fiduciary from entering into transactions with “disqualified

persons,” which mirror the parties-in-interest prohibitions in ERISA. The code also includes self-dealing and kickback prohibitions such as those under ERISA.

To prevent prohibited transactions, ERISA and the IRC provide exemptions, as does the DOL—both class and individual. These set forth specific criteria for how financial professionals can avoid PTs.

As seen here, ERISA and the IRC are generally more prescriptive than the Advisers Act regarding how to address conflicts. Notably, the exemptions do not resolve the aforementioned self-dealing, conflicts of interest and anti-kickback prohibitions through disclosure alone. In the absence of an exemption, such conflicts must be addressed via elimination of the prohibited conduct or, at least, by demonstrating that the facts and circumstances do not otherwise give rise to a conflict as contemplated under ERISA and the code. Walling off and other actions commonly taken by advisers under the Advisers Act may be adequate, but advisers should not automatically assume this is the case.

In summary, advisers and their compliance personnel should look to see if their conflict management efforts are adequate under the Advisers Act, as well as ERISA and the IRC. Written compliance procedures may have to be revised accordingly. Advisers should expect that SEC examiners will be looking for compliance under the two statutes as part of their regular examination process and under the SEC’s ReTIRE initiative. The inability to substantiate ERISA compliance to an examiner may lead to referral of the matter to the DOL.

David C. 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.