Originally published April 24, 2006
In its first individual prohibited transaction exemption published in 2006, the Labor Department conditionally authorized a broker-dealer to sweep uninvested IRA funds to a Free Credit Balance account, permitting the broker-dealer the use of those funds in its operations. PTE 2006-1, 53 Fed. Reg. 14005 (March 20, 2006).
The broker-dealer (Edward Jones) acted as an IRA custodian and, pursuant to the usual authorization from the IRA depositor, conducted daily sweeps of uninvested funds (e.g., interest and dividend income) to a money market mutual fund. The IRA’s were invested in a share class (Retirement Shares) that was not subject to a minimum average monthly account balance or fee. These practices resulted in a disproportionately large number of Retirement Share accounts with small (under $2,500) to very small (under $100) balances, which in turn increased the fixed costs attributable to and thus the expense ratio borne by the Retirement Share class (particularly the transfer and dividend disbursing agent fees that are largely based on the number of accounts and transactions). The Retirement Share expense ratio was more than 35% higher than the expense ratio for the Investment Share class, which was subject to a minimum average monthly account balance or fee. This expense ratio depressed the return of the Retirement Share class, effectively eliminated the return in the recent interest environment. (The exemption was requested in 2003.)
The broker-dealer proposed to address the dilution of return by prospectively imposing the minimum balance requirement on the Retirement Share class (under existing contractual authority), but noted that the monthly fee on small accounts falling below the minimum balance would more than offset any investment return at current market rates. The broker-dealer thus determined to make available its Free Credit Balance account as an alternative to the money market fund for its IRA sweep program. These accounts are customer cash accounts typically holding funds on deposit temporarily awaiting investment. Under the securities laws, funds in such accounts are:
- Payable on demand to the customer and available for trading and investment activity;
- Subject to special reserve requirements;
- Covered by SIPC insurance, if the account is properly structured; and
- Until repaid to the customer, used by the broker-dealer in its operations, thus reducing its borrowing needs.
Securities Exchange Act Rule 15c3-2 and -3. Because the Free Credit Balance could be viewed as an extension of credit from the IRA to the broker-dealer contrary to the prohibited transaction rules of Internal Revenue Code section 4975, the broker-dealer sought an exemption.
The Labor Department, which has been delegated authority over such exemption requests, granted the exemption on the following conditions:
- Neither the broker-dealer nor any affiliate has investment discretion or control or provides investment advice with respect to the uninvested IRA assets;
- The broker-dealer provides specified initial and ongoing written disclosures to the IRA independent fiduciary (i.e., the depositor);
- On the basis of the initial disclosure, the IRA depositor approves sweeping funds to the Free Credit Balance, which approval could take the form of negative consent;
- The IRA is credited with interest on its Free Credit Balance at an interest rate no less than either (i) the broker-dealer’s rate on non-IRA Free Credit Balances or (ii) the national index rate for interest checking as reported in the Bank Rate Monitor or (iii) 10 basis points; and
- The IRA depositor may withdraw the Free Credit Balance at any time without restriction.
It is interesting to note that the Department granted the exemption notwithstanding over 100 comment letters from IRA depositors questioning if not objecting to the exemption as proposed.
Please contact any of the following members of our Employee Benefits and Executive Compensation practice if you have any questions regarding this development:
George H. Bostick, Daniel M. Buchner, Adam B. Cohen, Ian A. Herbert, Alice Murtos, Robert J. Neis, W. Mark Smith, William J. Walderman, Carol A. Weiser and Brendan M. Wilson.
© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.
This article is for informational purposes and is not intended to constitute legal advice.