Margin purchases and short sales.

[Guest Thornton]

I have a physician client who is trustee of his retirement plan. There are several participants in a pooled investment arrangement (no direction). The client/trustee manages the plan assets for himself and the other participants (not wise, in my opinion). He wants to make margin purchases and short sales. Are these allowed under ERISA? Since purchasing on margin is essentially a loan from the brokerage house, could we have unrelated business income? Other ERISA issues? Thanks.

[QDROphile]

I wouldn't want to defend a fiduciary who engaged in margin transactions and short sales. The deck is stacked against you under the prudence requirements.

Short sales can be part of legitimate and prudent investment practices in a large fund with diversified investments, but I doubt that is what is going on here. There is a reason that we have so many jokes about physicians as investors.

Change the plan to allow separation of accounts for self direction. Also, make sure that the plan provides that unrelated business income taxes and the related adminstrative costs are charged only to the accounts that generate them.

[Kirk Maldonado]

Some people believe that simply filing the return to report the unrelated business taxable income may trigger an IRS audit of the plan.

[AndyH]

A related question:

I once handled a (always) one life DB plan (ignore the funding and 415 issues for purposes of this question) who told me year after year that he had been told (by my boss at the time) that he could make margin transactions ("naked options" were his words) on his 401(a) plan but could not do so if his plan was terminated and the assets rolled over into an IRA. That was his justification in his mind for keeping the plan even though it was fully funded.

My response always "Oh. Is that right?", or just silence.

Was/is this true?

[Erik Read]

I'd check with the wire house or brokerage. Most of them will not allow qualified plans to buy on margin or short unless the plan holds the shares long first.

I'd also check the investment policy - since you know he has to have one, and see if that will allow for margin or short sales.

Good luck.

[Jon Chambers]

ERISA prohibits transactions that could result in a loss greater than the account balance (I'm paraphrasing here). As a practical matter, that precludes almost all margin and naked option investments. Short sales are similarly questionable, unless the strategy is clearly defensive.

[AndyH]

Thanks, but would a one lifer be exempt from fiduciary standards governing such conduct because there are no non owner-employee participants?

[Jon Chambers]

I don't know. I always figured it was a funding issue, because if the account lost more than 100%, the participant (or somebody) would need to make up the difference, with no practical way to allocate, account for or otherwise fund the dollars contributed to the plan to make up for the loss. Anyone else have an idea or experience with this?

[Guest IWIS]

A case could be made that margin is imprudent for the reasons enumerated by QDROphile and John Chambers.

Another thing to keep in mind: a margin loan between a brokerage and a plan is a per se prohibited transaction. There's a class exemption for it: PTCE 75-1 (I believe), that allows for the transaction only if the proceeds of the loan are being used to invest in securities.

I've seen some fiduciaries use margin so that they can borrow against the plan for personal or business reasons. That is, they withdraw the proceeds of the margin loan from the brokerage account. That renders the original margin loan prohibited, as well as the subsequent withdrawal of the proceeds by the fiduciary.

In the cases with which I've had personal experience, criminal violations were also alleged by the DOL. I think it's because withdrawing money from a plan using margin is sometimes done as a way to justify the transaction or conceal it from participants (I've seen fiduciaries report gross assets on the Form 5500, ignoring the margin liability). In one of those cases, there was a conviction for embezzlement and falsification of documents under Title 18 U.S.C.

I'm not familar with the UBTI implications, but I've heard the same thing.