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I'm looking for some guidance on whether there are any restrictions on buying stocks on margin,

- within a profit-sharing plan?

- within a 401(k) plan?

- within an IRA?

Specific reasoning and/or cites would be appreciated. Thanks.

I'm a retirement actuary. Nothing about my comments is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial or consulting advice.

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Theoretically, plans and IRAs can borrow. However, that causes the income that they recognize to be subject to income tax under the unrelated debt-financed income rules. Also, the prohibited transaction rules often come into play because of the way in which the transactions are structured.

Kirk Maldonado

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ERISA prohibits transactions that can result in a loss greater than account value. This is the primary rationale most institutions use to prohibit margin trades. Furthermore, margin interest paid may constitute a PT if the margin lender is also the trustee.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Guest reg_h2b

There is an easy way around the margin problem at least for stock indices in IRAs.

You can get the effect of "margin" by buying a mutual fund that is "leveraged". There are some index funds that have a daily return 1.5 times or 2 times the return of the underlying stock index (eg nasdaq 100). The mutual fund creates this effect by futures, options, and swap agreements.

There is a similiar problem with shorting a stock in an IRA. But here again there are mutual funds that allow you to receive the daily% return of -2 times the underlying stock index.

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See PLR 8708031. The IRS appears to draw a distinction between borrowing money and buying on margin.

There are other rulings out there, and I do not pretend to be up to date on the issues.

My advice to pax is that if you are not willing to research the UBTI issues, don't do it.

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Jon- buying stock on margin using funds loaned by a party in interest (e.g., broker/ dealer) is permitted by DOL opinion 86-12A.

Only fiducaries are prohibited from loaning funds to the plans.

There is nothing inherently illegal in a plan entering into margin loans secured by stock or other assets - just that the gains are subject to UBIT at the rate for trusts, e.g., 40% income tax rate for gains in excess of about $9,000. However, there is a large fiduciary risk if the stocks used to secure the loan are subject to a margin call and participant's account balnace are decimated.

Also there are hidden margin risks in investments in leveraged limited partnerships. Plans that invest in such instruments will be suprised by UBIT at the end of the tax year with a 1099 form. I would review the prospectus for any of the "leveraged funds" recommended for IRAs to make sure that there is no borrowed money used to purchase the funds which will result in UBIT tax.

mjb

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mjb--

As I noted in my earlier post, the PT becomes an issue if the loaning party is also the trustee. I concur that it's not a PT if the loan comes from a non-trustee/non-fiduciary brokersgreater than account value as the rationale why most providers don't permit this strategy, not as a legal prohibition. If the stock price declines, the broker/dealer may need to make a margin call, but there may be no way to inject funds into the account. Assuming a 50% margin, if the margined stock drops 50%, the account is wiped out; if it drops more, the account goes negative. For this reason, most brokers don't permit margin trades.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Jon I concur except that not all trustees are fiducaries-- many trustees are nondiscretionary trustees, i.e., they only respond to instructions received by the employer or investment advisors. Hence they are not fiducaries under ERISA. Also HR -10 plans can use custodians to hold plan assets. Finally There are some financial entities that are affilated with broker dealers that offer margin loans for both personal assets and pension plans as part of a line of credit to a busiesss. I know of a PS plan that got a margin call from the fiancing entity which wiped its assets.

mjb

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Respectfully, a trustee is always a fiduciary by definition, hence any loan from a trustee is potentially a PT, absent some exemption. Whether or not the trustee has discretion over investments is irrelevant. I agree that it may be possible to trade on margin, when the margin loan comes from a non-fiduciary, but I stand by my earlier comment that the vast majority of broker-dealers that I have experience with don't permit margin loans on qualified plan assets, even when they are not acting as trustee.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Jon- There is a common misconception by investment advisors and attorneys that a trustee is automatically a fiduciary and therefore is the "deep pockets" in the event of the loss of assets. A trustee can only be a fiduciary to the extent the trustee agrees to excercise discretion over the assets under its control or performs an ERISA fiduciary function. A fiduciary relationship cannot arise by default or merely because the trustee is the owner of the assets. There is plenty of case law under federal and state law that absolves trustees with no discretion to act on behalf of plan assets from liability for misuse or loss of plan assets under their control if they could not act without instruction from another person. Ask Robert Metz, the former wall st. journal reporterabout that. Most investment advisors and employers pay little attention to the trust documents of directed trustees which requires that instructions be provided for any action involving investment or distribution of plan assets. The financial institutions require those provisons to limit their liability in the event of a loss of plan assets. I would be please to provide you with the Metz case upon your request . I spend a lot of time reviewing such documents and advising plan sponsors on the liability issues.

mjb

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mjb, let's get back to first principles. Here is a direct copy from ERISA, defining party in interest:

"(14) The term ``party in interest'' means, as to an employee benefit plan--

(A) any fiduciary (including, but not limited to, any

administrator, officer, trustee, or custodian), counsel, or employee of such employee benefit plan;"

Note that the trustee is by definition, a party in interest.

Moving to the prohibited transaction issue, we find:

"Sec. 1106. Prohibited transactions

(a) Transactions between plan and party in interest

Except as provided in section 1108 of this title:

(1) A fiduciary with respect to a plan shall not cause the plan

to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect--

(A) sale or exchange, or leasing, of any property between

the plan and a party in interest;

(B) lending of money or other extension of credit between

the plan and a party in interest;"

Consequently, it's clear that the trustee, as a party in interest, cannot extend credit to the plan, unless the DOL advisory opinion you referred to above (86-12A) also applies to trustees (I don't have that opinion, and couldn't find it on the Web).

Moving to the ERISA definition of "fiduciary", we find,

"(21)(A) Except as otherwise provided in subparagraph (B), a person is a fiduciary with respect to a plan to the extent (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, ..."

I find it hard to believe that even a fully non-discretionary trustee could not be found to have no "authority or control respecting management or disposition of (a plan's) assets". I've never seen a trust agreement claiming a non-discretionary trustee was not a fiduciary at all, although I'm very familiar with agreements that seek to significantly limit the trustee's fiduciary liability. As an advisor to plan sponsors, you may want to review my paper on this topic, at the following link.

http://www.advisorsquare.com/advisors/schu...ns/82713136.pdf

I think your confusion may stem from the difference between an "investment fiduciary" (I agree a non-discretionary trustee is not an investment fiduciary), and a general fiduciary. I'd be interested in your rationale if you believe that it is possible to be a trustee without being a fiduciary in any sense of the term.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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Jon my analaysis is based upon the principle that to be a fiduciary a person must agree to excercise some discretion over plan assets. A party who under the terms of the opertative agreements can only act upon the instruction of another person is not a fiduciary regardless of whether they have legal title to the assets and is designated as the trustee. In the Metz case Metz deposited $400k into an IRA with a bank named as trustee. Metz later instructed the bank to transfer $360 k to another IRA operated by Metz's investment advisor. The advisor absconded with the money and Metz sued the bank for a breach of fiduciary duty in not reviewing the backound of the advisor before releasing the funds. The bank prevailed because Metz had signed an agreement that the bank would not be liable for transactions excuted by the bank based upojn directions received from Metz. This is sop for all banks that are not acting as an investment advisor. The ERISA case law is the same. All bank documents that I review have similar language that requires instruction from a representative of the plan before funds will be transferred/ invested unless the bank is being paid a fee for investment advice.

As noted in the definition of a fiduciary, the key is the word "discretionary" . Without discretion a trustee is not a fiduciary under ERISA regardless of the title under which the property is held. This is settled case law. I don't know of any financial institutions that use f word in ERISA trust documents unless they are being compensated for discretionay investment of assets because there is no reason to take such a risk.

mjb

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I have to differ. I don't know of any institutional trustees that DON'T use the term "fiduciary", although obviously they will make it clear in what capacity they act as fiduciary, and don't take investment discretion unless they are being paid for it. Some of the trust companies my clients work with include Union Bank of California, Charles Schwab Trust Company, Wells Fargo Bank, CNA Trust, Vanguard Fiduciary Trust Company (note the name), Bank of America and Fidelity. I'd be very interested in hearing what trustees you run into that claim not to be a fiduciary.

If you go to the second part of the ERISA fiduciary definition, it continues "...or exercises any authority or control respecting management or disposition of its assets, ..." Obviously, a trustee meets this definition, since they are the only entity that can physically make a disposition.

On a separate note, the February 4th issue of Pensions & Investments has an op-ed piece on fiduciaries. They indicate that ERISA has no clear definition of fiduciary, and indicate that it is sometimes unclear as to who is a fiduciary. They cite actuaries and investment consultants as examples, but don't even touch on the issue of trustee.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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I finally found the right cite as to whether a trustee must be a fiduciary. It's found in 29CFR Sec. 2509.75-8. Here's the relevant info.

"D-3 Q: Does a person automatically become a fiduciary with respect to a plan by reason of holding certain positions in the administration of such plan?

A: Some offices or positions of an employee benefit plan by their very nature require persons who hold them to perform one or more of the functions described in section 3(21)(A) of the Act. For example, a plan administrator or a trustee of a plan must, be the very nature of his position, have ``discretionary authority or discretionary responsibility in the administration'' of the plan within the meaning of section 3(21)(A)(iii) of the Act. Persons who hold such positions will therefore be fiduciaries."

Hope this puts to bed the question of whether you can be a trustee without being a fiduciary.

On the issue of range of trustee responsibilities, and the Metz case cited above, note the following conflicting conclusion from a Kilpatrick and Stockton article http://www.kilstock.com/site/print/detail?...rticle_Id=1031:

"In Arakelian v. National Western Life Insurance Co., [755 F. Supp. 1080 (D.D.C. 1990)], the trustees argued that they were not fiduciaries because they had never exercised their fiduciary powers and had delegated plan administration to the insurance company from which they had purchased a group annuity contract. The court held that "[t]he fact that all administrative functions of the Plan were delegated to the Plan administrator (National Western) did not and does not absolve the trustees of their duty to review and insure that the administrator was acting in the best interests of the participants." [id. at 1084]"

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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I would agree with Jon. The fact that a trustee does not proactively select the investments of a plan does not absolve them of responsibility to monitor investments that might be imprudent, due to excessive risk, or illegality etc.

I do not have the cite, but I recall that a few years ago the PWBA successfully prosecuted a bank trustee for failing to use due diligence in monitoring an ESOP that used questionable valuations.

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Jon: The regulation you cited in your last post is a 25 year old opinion of the US Labor Dept and is not the standard used by the Courts to determine fiduciary liability of a trustee under ERISA. In Beddall v. State St. Bank and Trust, 137 F3d 12 (1998), the First Circuit Court of Appeals held that a bank acting in the capacity of a trustee for assets of a qualified plan was not an ERISA fiduciary merely because the bank held legal title to the assets and perfomed certain administrative functions for the plan. The bank had been sued by the fiducaries for an Eastern Airlines pension plan because an investment manager appointed to manage the real estate portion of the plan had over valued the assets. The court stated the term fiduciary is functional and a party must have discretion over the plan assets to be fiduciary. Where a trustee acts on the instructions of a duly appointed advisor (the RE manager) or other plan representative, the trustee is performing a ministerial function, not a discretionary function and is not a fiduciary because it follows such instructions in disposing of plan assets. The Court also cited several prior cases for this principle. By the way the Beddell case did not even review the regulation you mentioned in your last post indicating that it has no weight in a judical review if the trustee has no discretion.

The case you cited is not on point either because it deals with plan fiducaries who had the obllgation under the Plan to review the acts of the administrator they hired but failed to exercise it. They are no different than the fiducaries for the Eastern Airlines pension plan who had the obligation to review the actions of the RE manager who they appointed but that does not make the bank fiduciary because it followed the manager's instructions.

mjb

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Hey mjb--

Slow down a little here. I never said that a trustee has to have investment discretion, or needs to be responsible for a plan's investments. In fact, most trustees don't have that role or responsibility, because it is retained by the sponsor, or delegated to an investment manager. I merely said that a trustee is, by definition, a fiduciary. I then cited the ERISA reg that says that a trustee is a fiduciary. This whole conversation started because we were investigating whether or not a margin loan would be a prohibited transaction, a question that comes under the purview of the DOL. You may be right that courts don't care about DOL regs, and that they will adopt a functional definition of fiduciary status that is entirely dependent on whether or not the entity holds investment discretion. That doesn't change the fact that the DOL says a trustee is a fiduciary by definition, that just about every professional trustee will accept limited scope designation as a fiduciary, and that loans from fiduciaries may constitute a PT, absent an exemption. Are we in agreement on those points? If so, I don't think there is anything we disagree on.

Jon C. Chambers

Schultz Collins Lawson Chambers, Inc.

Investment Consultants

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I think that people are getting confused because they think that if you are a fiduciary, then your fiduciary responsibilities extends to everything that could go wrong.

A person is a fiduciary with respect to certain functions, not every conceivable function that could arise under the plan.

Also, I concur in Jon's remarks.

Kirk Maldonado

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I concur except to note that a person is only a fiduciary under ERISA to the extent that they perform a fiduciary function under Section 3(21(A). Advisors have duty to determine if a party is a fiduciary under the law and this requires a review of the operative documents and fiduciary status cannot be based on a title such as trustee.

mjb

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