Broker-Dealer SEC Rules

[Guest Jeff Kropp]

Our client has a 401(k)/403(B) plan for its employees, to which it also makes employer contributions. If the participant fails to sign an election form, employer contributions are placed in a suspense account until the form is completed. The suspense account earns no interest. The employer would like its contributions to earn some interest until the employee completes the election and investment option forms. The broker-dealer that services the plan has indicated the SEC prevents money from being invested prior to the receipt of employee forms. Can anyone point me in the right direction with regard to SEC rules that govern broker-dealer conduct so I can see verify the broker-dealers conclusion.

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[Guest DavidMCohen]

The broker appears to be hiding behind the know your customer rule. In fact, this is why I have advised a number of my B/D clients that the IRS approved 401(k) default election does not work. On the other hand, the B/D is telling a tall tale. Even without the form they could put the money into their proprietary money market fund. Your client should insist on this and take the argument up the chain at the brokerage house.

[Guest Jeff Kropp]

I don't know what you mean by saying the broker is hiding behind the know your customer rule. The first issue is whether participants in the plan must sign a disclosure form (the same form an individual off the street has to fill out when establishing account) or is there an exception for benefit plans. Second, assuming that the form is needed, is there a rule that prevents the broker from investing the money until the form is completed (both employer constributions and employee deferrals),

Any help is greatly appreciated.

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[IRC401]

I'm no SEC guru. Nevertheless, I can assure you that there is no requirement for a participant to sign anything in order to have an account with profit-sharing contributions. (He needs to sign a salary deferral agreement top make 401(k) contributions.)

The account should be in the name of the plan trustee, not the employee. The trustee can set up the account and direct the investment of money allocated to the account (and may be committing a breach of fiduciary duty by putting money in a non-interest bearing checking account). On the other hand, the employer may require an employee to complete forms as a condition of participation, in which case no money should be allocated to the account of the participant before the forms are completed.

[Guest Jeff Kropp]

IRC401, I am not sure that you understood the issue (which is a securities issue). The issue is whether there are disclosures that a broker must obtain from participants before setting up an account, in addition to the usual benefits election forms. I have since found that the answer lies in the NASD regulations applicable to NASD brokers. The broker must take reasonable efforts to obtain certain information, including whether the participant is related to a NASD member. However, there appears to be an exception for opening an account in open-ended mutual funds where the broker is not giving investment advise.

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[Guest DavidMCohen]

There is no form that an individual or a benefit plan participant has to fill out to open an account at a B?D. Rather, there is a customer profile that the broker is supposed to fill out before he or she starts trading the account. this profile is required because of the Federal securities law and common law requirements referred to as the Know your Customer Rule. If money is going in to the B/D and not being invested, then it is likely that the B/D is using that money for its own business needs. that would be OK because this money is a free credit balance. however, from an ERISA standpoint free credit balances are extremely suspect (although there is a very old IRS (but post-ERISA) IRS letter that OKs free credit balances as long as the B/D pays interest. I believe the letter was issued to Sanford Bernstein. In the meantime, i know of no reason why the money is not being swept into the broker's standard sweep vehicle until the individual does whatever the B/D wants so that it is comfortable that it has satisfied its duties to know its customer.

[Kirk Maldonado]

While being pretty ignorant on the rules regulating broker/dealers, it seems that this situation is fair similar to where the bank/trustee decides to hold some of the assets of the plan in a non-interest bearing account, or where it places the money in its proprietary sweep account. It would seem to me that any time the broker/dealer is exercising discretion to keep the funds in a non-interest bearing account (which presumably benefits the broker/dealer) or in an account where broker/dealer earns any fees, there is a prohibited transaction.

[Guest P A Weick]

Seems to set up a Hobson's choice for the BD: either violate the NASD's know your customer and suitability rules (and possibly lose your securities license) or violate the prohibited transaction rules (and incur liability to the plan participant who is not returning the information the broker needs). Is there some sort of middle ground where the broker could get direction from the plan sponsor/administrator to hold all assets in an interest bearing mutual fund (for which the broker gives no investment recommendation) until sufficient information is received to allow the broker to make suitable recommendations? Or would that bring a risk of losing the 404© protections the plan sponsor/administrator designed the plan to avert?

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[This message has been edited by P A Weick (edited 10-23-1999).]

[IRC401]

If the broker is deciding where money will be invested, it is a fiduciary, and it seems to me that it would be a breach of fidicuary duty to invest the money in a non-interest bearing checking account. (It may be a breach to put it in an interest bearing checking account.)

If the plan trustee (who is the legal owner of the account) directs the broker where to invest the money, I don't see how NASD has any basis for a complaint (although that is not my area of expertise). If the trustee directs how the money will be invested, there would be no ERISA 404© protection (which may be meaningless anyway). If the client wants the plan to comply with 404©, it should not deposit any money for the participant until the forms are completed, and if the borker has taken it upon it self to help the sponsor comply with 404©, it should refuse to accept any contribution for a participant who has not filled out the forms.

[Guest DavidMCohen]

I am not convinced that the standard automatic sweep into the propritary money market fund pending investment instructions necessarily represents a suitablility or know your customer violation.

If the sponsor were to open a separate account within the plan for undirected monies, the account could be swept. I guess it becomes an accounting nightmare if you have to parcel out the earnings to more than one person. With respect to 404©, the only real solution is to refuse to take in money until the EE has completed all necessary froms. And by the way, if the client is big enough, I would insist that an RR comes to the workplace to handle these situations.

[Dowist]

To restate the conversations somewhat, the issue seems to be whether the broker's client is the trustee of the plan or the participant.

If the client is the trustee, I would think it would insist on the sweep of univested contributions - probably a violation of its responsibilities if it allows the broker to get the earnings.

It is possible I suppose that the participant is the client for the participant's account - although the assets are legally owned by the trust. The only scenario in which the participant could be the client would be in an ERISA ss 404© situation - otherwise the trustee is responsible for investments. And even if you had an ERISA ss 404© situation, to the extent that the participant doesn't give investment directions, the trustee is still responsible.

Question: are the contributions going into a noninterest bearing account of the broker. I think this would be a big problem for the trustee, and probably for the broker as well - he's getting a benefit from plan assets based on his relationship with the plan.

[Kirk Maldonado]

Maybe I'm being overly simplistic, but I don't think the the fact that the plan fiduciaries would lose the protection from liability provided by ERISA Section 404© (if the funds were invested without direction from the participants)would allow the broker/dealer to commit a prohibited transaction (by being able to keep the money without paying interest on it).

[Guest Jeff Kropp]

Thanks for all of your helpful comments. In a nutshell, it appears that under ERISA, employer contributions must be invested in a conservative default account pending investment direction from a participant. 404© protection is lost, but it is lost whenever a default account is selected by an employer. As far as the Know Your Customer Rule, an argument could be made that most of the required information is already provided to the broker by our client at the outset(except for employee's signature and statement that employee is not associated with a NASD member). Alternatively, the employer/trustee could be the "customer" for purposes of the Rule, in which case no statement is needed from employees for contributions to a default account. To be conservative, the employer could designate a mutual fund as a default account (as long as the broker did not advise the employer on the selection), in which case an exception to part (B) of the Rule applies (the part that requires employee's signature and statement that employee not associated with NASD member).

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