Kim Shaw Elliott | The Wagner Law Group

Reimbursing an Employer for Paying Plan Expenses 

2025-04-22T18:58:18Z

Sometimes, it is more efficient for an employer to pay the expenses of a retirement plan rather than the plan paying for them directly.  If the expense paid is otherwise appropriate, the employer can then be reimbursed by the plan from plan assets.  This includes payments made to third party providers for necessary services. Employers may be reimbursed for expenses paid on behalf of retirement plans if:

The expense meets other tests for being reasonable and necessary,
The payment is consistent with the terms of the plan document, and
An agreement between the plan and the employer permits reimbursement. While no authority requires this, a payment agreement will help protect the plan fiduciaries.

What is a reasonable and necessary plan expense? The Employee Retirement Income Security Act of 1974 ("ERISA") is the major law that governs the operation of retirement plans.  Its paramount purpose is to protect plan assets so that they are available to pay benefits to plan participants and their beneficiaries in accordance with the terms of the plan.  Accordingly, ERISA includes strict provisions, called "prohibited transactions", that disallow payments and other transactions that might not further that essential purpose of paying benefits. In what at first seems like monumental overkill, ERISA prohibits providing any services to a plan.  It then, however, provides exemptions from those prohibited transactions that permit running the plan's operations.  Those arrangements must be reasonable in nature, necessary for establishing or operating the plan, and no more than reasonable compensation may be paid for those services.  Additional rules require full disclosure of the services to be provided and the compensation to be paid.  With that information, a plan fiduciary can assess, prior to approving any arrangement, if it is reasonable. Plan fiduciaries are encouraged to carefully review any proposed arrangement with a plan and to understand the marketplace so that only reasonable and necessary expenses will be paid from a plan.  This includes contracts to provide essential administrative services. Why does reimbursing an employer with plan assets raise any concerns? ERISA also prohibits transferring any assets from a plan to a party in interest as well as lending money or any extension of credit between a plan and a party in interest.  An employer, acting as the plan sponsor or responsible plan fiduciary is a party in interest to the plan.  Paying expenses in advance and then being reimbursed by the plan might be viewed as a short-term loan from the employer to the plan.  Additionally, a plan fiduciary may not deal with the assets of the plan in his own interest or for his own account so any payment from a plan to a fiduciary must be strictly scrutinized for any self-dealing. So long as the services are necessary and the arrangements for the services and compensation to be paid are reasonable, as stated above, the expenses are appropriate plan expenses and payment for them is exempted from the prohibited transactions.  If the employer has a conflict of interest in being reimbursed, however, that is a separate and distinct prohibited transaction. How can a plan document address reimbursements? ERISA requires that all plans be operated in accordance with the strict terms of the plan document.  If the plan document states that all expenses will be paid by the employer, and nothing more, then reimbursement is a direct violation.  If the plan specifies that all expenses will be paid by the plan and leaves the details open, reimbursement might be acceptable. A clearer approach would be for the plan to specify that expenses of the plan shall be paid from the plan assets unless paid by the employer and that the employer may advance expenses and benefits on the plan’s behalf and be reimbursed from the plan’s assets for those advances. How can the reasonableness of reimbursement arrangements be strengthened? An argument that being reimbursed is really part of a loan from the employer to the plan can be mitigated by an agreement that the employer will pay certain expenses directly to the provider and that the plan will reimburse the employer.  No interest will be charged or received and repayment will be made within 60 days of notification. Conclusion: With special care to ensure that any expenses incurred by a plan are necessary and reasonable, an employer should be able to pay those expenses in advance and receive reimbursement from the plan in accordance with the terms of the plan document. [author] [author_image timthumb='on']https://www.wagnerlawgroup.com/wp-content/uploads/sites/1101401/2021/07/kim-shaw-elliot-photo.jpg[/author_image] [author_info]Kim Shaw Elliott is an ERISA investment lawyer, engaging in a multi-disciplinary practice helping clients successfully navigate the complex intersection of ERISA, securities law, broker-dealer regulation and tax regulation. [/author_info] [/author]

Treasury’s Record $4.3B Crypto Exchange Fine Adds to Pressure on Digital Assets

2023-12-05T16:43:58Z

Treasury’s Record $4.3B Crypto Exchange Fine Adds to Pressure on Digital Assets - Kim Shaw Elliott, Chief Investment Officer, November 29, 2023 (PDF)

Crypto Remains Massive Compliance Risk for Retirement Fiduciaries

2023-12-05T16:53:58Z

Crypto Remains Massive Compliance Risk for Retirement Fiduciaries - Kim Shaw Elliott, PLANADVISER, November 27, 2023 (PDF)

SEC Case Highlights Why Fiduciaries Should Be Cautious About Crypto

2023-12-05T16:39:25Z

SEC Case Highlights Why Fiduciaries Should Be Cautious About Crypto - Kim Shaw Elliott, PLANSPONSOR, November 22, 2023 (PDF)

SEC Charges Against Kraken Identify Specific Tokens as Securities

2023-12-05T16:17:32Z

SEC Charges Against Kraken Identify Specific Tokens as Securities - Kim Shaw Elliott, PLANADVISER, November 22, 2023 (PDF)

The SEC Fires All Guns Against a Crypto Platform Plan Fiduciaries Should Take Note

2023-11-22T15:57:16Z

By Kim Shaw Elliott The SEC announced November 20 that it has charged Payward Inc. and Payward Ventures, Inc. (together “Kraken”, an online crypto platform) with a litany of securities registration failures and other wrongdoing which took place since 2018. In a straightforward press release (the “SEC Release”), the chief securities regulator laid out its view of what is wrong with Kraken, which may be a typical crypto provider: “Through its platform’s services, Kraken allegedly:

Provides a marketplace that brings together the orders for securities of multiple buyers and sellers using established, non-discretionary methods under which such orders interact, and thus operates as an exchange;
Engages in the business of effecting securities transactions for the accounts of Kraken customers, and thus operates as a broker;
Engages in the business of buying and selling securities for its own account without an applicable exception, and thus operates as a dealer; and
Serves as an intermediary in settling transactions in crypto asset securities by Kraken customers, and acts as a securities depository, and thus operates as a clearing agency.”

Those statements read like a primer on the subject of SEC-required registrations. The SEC Release went on to explain:

“In case after case, we’ve seen the consequences when individuals and businesses tout and offer crypto investments outside of the protections provided by the federal securities laws: investors lack the disclosures they deserve and are harmed when they don’t receive them,” said Gurbir S. Grewal, Director of the SEC’s Division of Enforcement. “Today, we take another step in protecting retail investors by shutting down this unregistered crypto staking program, through which Kraken not only offered investors outsized returns untethered to any economic realities, but also retained the right to pay them no returns at all. All the while, it provided them zero insight into, among other things, its financial condition and whether it even had the means of paying the marketed returns in the first place.”

Registration is expensive and time-consuming, and requires a large and sophisticated staff, detailed recordkeeping, large technology investment, and ongoing disclosures. As Mr. Grewal noted, however, it is these very activities that help guide and protect the public in their investment choices. Why then would plan fiduciaries clamor to offer crypto through their 401(k) plans? Is it a prudent decision to offer unregistered securities through unregistered vehicles to plan participants who are not likely to be sophisticated investors? The DOL has already cautioned plan fiduciaries to “exercise extreme care before they consider adding a cryptocurrency option to a 401(k) plan's investment menu for plan participants.” (See Compliance Assistance Release No. 2022-01, the “DOL Release.”) Fiduciaries are well-reminded of the basic responsibilities imposed on them by ERISA. The DOL Release provides a nice summation of those duties:

“When defined contribution plans offer a menu of investment options to plan participants, the responsible fiduciaries have an obligation to ensure the prudence of the options on an ongoing basis. Fiduciaries may not shift responsibility to plan participants to identify and avoid imprudent investment options, but rather must evaluate the designated investment alternatives made available to participants and take appropriate measures to ensure that they are prudent. As the Supreme Court recently explained, ‘even in a defined-contribution plan where participants choose their investments, plan fiduciaries are required to conduct their own independent evaluation to determine which investments may be prudently included in the plan's menu of options.’ The failure to remove imprudent investment options is a breach of duty.”

Each investment option on a 401(k) plan menu (including a brokerage window that gives access to crypto) should be selected in accordance with the duty of prudence under ERISA. Prudence requires a fiduciary to act “with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” Courts have interpreted this duty as requiring plan fiduciaries to conduct an independent investigation of the merits of each of the plan’s selected investments as seen in the context of the overall portfolio. (See, e.g., Donovan v. Cunningham, 716 F.2d. 1455 (5th Cir. 1983), cert. denied, 469 U.S. 1072 (1984)). Each investment choice in the plan menu must be a prudent investment option. (Preamble to DOL regulations under ERISA Section 404(c), 57 Fed. Reg. 46922 (Oct. 13, 1992)). Appropriate consideration should be given to all relevant factors concerning a particular investment, including the role the investment fund will play in the plan’s investment menu and a consideration of the risk of loss and the opportunity for gain. (See 29 C.F.R. 2550.404a-1(b)(1)). The fiduciary should consider all relevant information concerning the fund, highlighting both the merits and possible drawbacks. The fee structure should be fully vetted and understood. A fiduciary’s duties do not end with selecting a fund. They have a duty to monitor their plan’s investments or investment menu choices at regular intervals to ensure that each investment remains prudent. The investment review process should be properly documented. Plan service providers, such as a custodian for the investment, should be similarly vetted. An early-to-market crypto recordkeeper, ForUsAll, filed suit against the DOL, claiming that the “extreme care” warning in the DOL Release was an “arbitrary and capricious attempt to restrict the use of cryptocurrency in defined contribution retirement plans…” The court rejected those claims and dismissed the suit. See ForUsAll Inc. v. U.S. Department of Labor et al, 22-cv-1551 (CRC) (D.D.C. Aug. 29, 2023). The opinion reasons that, “the Release does not extend fiduciary obligations to a previously duty-free domain or alter existing obligations in any way. It merely states that plans offering cryptocurrency options through their brokerage windows should be prepared to explain how those actions comport with their duties of prudence and loyalty—whatever those duties are.” Plan fiduciaries should be prepared to document how this can be accomplished without financial disclosures and the investment information presented in a prospectus and other documents required for registered securities. Is it prudent to place faith in the seller or holder of crypto who does not go through the rigors of registration? While some registered broker dealers are now offering crypto to 401(k) plans through registered exchange traded funds, a fiduciary must still weigh the risk of loss against the opportunity for gain from these highly volatile investments. The SEC’s new enforcement activity should be a clear warning to not only unregistered crypto providers and the advisers who recommend crypto investments, but also to retirement plan fiduciaries who approve those investments. The DOL announced in the DOL Release its plan to initiate a new investigative program for plans that offer crypto, whether as a direct investment or through brokerage windows. Stay tuned for the next regulatory axe to fall.

Secure Act 2.0 Litany of Retirement Change Presents Employers Enhanced Retirement Opportunities for Employees

2023-02-07T17:18:12Z

Secure Act 2.0 Litany of Retirement Change Presents Employers Enhanced Retirement Opportunities for Employee - Marcia Wagner, Dannae Delano, Alexander Olsen, Kim Shaw Elliott and Barry Salkin, Bloomberg Tax, Tax Management and Compensation Journal, Vol. 52, No. 02, February 3, 2023

If You Give Rollover Advice to IRA Owners Act Now: The Compliance Deadline Has Passed

2022-11-07T17:01:59Z

If You Give Rollover Advice to IRA Owners Act Now: The Compliance Deadline Has Passed - Marcia S. Wagner and Kim Shaw Elliott, Investment & Wealth Institute, September/October 2022

Massachusetts, Pennsylvania and New Jersey Taxpayers Beware

2022-10-03T13:58:16Z

Massachusetts, Pennsylvania and New Jersey Taxpayers Beware: Don’t Let a Mismatch between Your State’s Tax Laws and the Federal Rules for Deducting Contributions Result in Overpaying Your State Tax on Retirement Distributions. Recordkeeping and Professional Advice Are Key.

Kimberly Shaw Elliott, Esq. and Regina Snow Mandl, Esq. Due to an arcane mismatch in rules, you might inadvertently pay too much tax on distributions from your retirement accounts. Most states follow the federal rules so this may be a problem in only a few states. In those few, however, the mismatch could inadvertently result in you erroneously paying significant additional state income taxes. Massachusetts is an outlier, along with Pennsylvania and New Jersey. Your State Might Not Permit a Deduction for Contributions, Even When Federal Law Does Withdrawals from retirement accounts are taxable for both federal and state purposes to the extent they are determined to consist of contributions that were not previously subject to tax. This makes sense. If you received a deduction for a contribution, such as to an IRA, or were not taxed on a contribution, such as to a 401(k) plan, the contribution, along with tax-deferred earnings on that contribution, become taxable when they are distributed. On the other hand, if you make a non-deductible contribution to an IRA you have a “basis” in that contribution and need not be taxed when that basis is returned to you. Most states follow the federal income tax rules so the return of basis is the same for purposes of determining your federal income tax and state income tax. Massachusetts, Pennsylvania and New Jersey are the contrarians. In those states, any contribution that was not tax deductible when it was made should be withdrawn as a “return of basis” and not taxed. If you are not aware of this, you might report a distribution in the same amount on both your federal and state income tax returns. This would result in your paying tax twice: once when you made the contribution, and again when you withdraw it. Example of a Mismatch- Massachusetts Since Massachusetts does not allow a deduction for amounts originally contributed to an IRA, the distributions are not taxable until the full amount of your contributions which were previously subject to Massachusetts taxes are recovered. As an example, assume that in 2010 you made a $5,000 contribution to your IRA. If you met the income limitations for a deductible IRA for that year, you could have deducted the contribution on your federal income tax return. If you lived in Massachusetts, however, you could not have deducted the contribution on your state income tax return. Assume that in 2021, the account has grown to $8,000 and you withdraw the entire account value. For federal tax purposes, you have no basis in the account because none of it has been previously taxed. You should add the entire $8,000 as ordinary income to your federal income tax return ($8,000 gross ordinary income equals $5,000 contribution that was previously deducted plus $3,000 gain that was tax deferred while accumulating in the IRA). For your Massachusetts return, you have already been taxed on the $5,000 contribution but the $3,000 gain has not yet been included in income. You therefore should add only $3,000 as ordinary income to your Massachusetts return ($8,000 less $5,000 return of basis equals $3,000 gross ordinary income). Know Your State’s Rule and Keep Records to Avoid Overpaying State Income Tax Taxpayers who are unaware of this disparate treatment may pay too much state income tax. It is critical, therefore, to know your state’s rules, or work with a competent tax adviser who does. It is also important to keep clear records of your non-deductible contributions throughout the years. Nondeductible IRA contributions are recorded each year via IRS Form 8606. That form is also used to report distributions from traditional, SEP or SIMPLE IRAs (if you have a basis in them), as well as conversions to or distributions from Roth IRAs. These forms are important to have on hand as you prepare your returns for years in which you receive distributions. But Form 8606 does not report amounts that are not deductible in your state. For added protection, we suggest that you also maintain a spreadsheet that records all of your IRA contributions, deductions claimed for contributions (state and federal), all distributions from those accounts, and related dates. State Rules Vary Significantly Currently, eight states—Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming—have no state income tax at all. If you are lucky enough to live in one of those states, mismatched basis is not an issue for you. Some states have income taxes but exclude distributions from employer-based plans and IRAs. Others exempt distributions but impose age or other limitations. Still others may pro-rate distributions so that each payment is partially taxable and partially a return of basis. As the example above illustrates, Massachusetts is among those that permit previously taxed contributions to be returned tax-free first. Further complications arise when you move. If you lived in a state that follows the federal rules when you made a distribution but lived in a state where you could not deduct your contribution when it was made, the second state may or may not have a mechanism by which your basis can be recognized and be reduced from taxable income. Massachusetts considers the contribution to be a return of basis only if it was previously taxed by Massachusetts. Vigilant taxpayers must become well-informed to navigate these complex rules. Once again, adequate records and professional advice are key to your success.

DOL Drops ‘Bomb’ On Advisors Who Give Advice To IRA Owners

2022-06-28T15:20:34Z

DOL Drops ‘Bomb’ On Advisors Who Give Advice To IRA Owners - Km Shaw Elliott, InsuranceNewsNet, October 22, 2021

SEC Extracts $96M Settlement from TIAA Subsidiary for Rollover Practices – This is Only the Beginning

2022-10-03T13:53:05Z

[caption id="" align="alignleft" width="159"] Kim Shaw Elliott[/caption] The Securities and Exchange Commission (“SEC”) beat the Department of Labor (“DOL”) to the punch and announced a major settlement with a broker dealer arising from its rollover practices. In what is likely the first of many prosecutions to come, the SEC hit hard and extracted a $96 million fine from a TIAA-CREF subsidiary. This action also resolved a parallel action by the Office of the New York Attorney General. TIAA-CREF Individual and Institutional Services, LLC (“TIAA Sub”), a subsidiary of Teachers Insurance and Annuity Association of America (“TIAA”) is alleged to have failed to adequately disclose conflicts of interest and to have misled customers. Dually registered as a broker dealer and an investment adviser, TIAA Sub was charged with incenting or pressuring its advisors to recommend that participants in retirement plans record kept by the parent company roll assets out of those employer-sponsored plans into TIAA Sub’s more expensive managed account program. Those incentives and pressures included paying more variable compensation than what was paid for alternative programs and punishments for failure to meet sales targets. Pressure to Sell the Managed Account Program. Seeing the leakage from assets it held as plan participants retired, TIAA Sub created a new division to offer managed accounts. Rather than move assets to other providers, retiring participants could move their account to the managed program. They were encouraged to bring in new assets also. Fees ranged from .40% to 1.15% of assets per year (in addition to fund costs), compared to no additional fees for accounts held in the employer-sponsored plans. Advisors were trained to recognize the “pain points” for those clients and to convince them that the managed option was the right solution for them. Advisors were paid significantly more for putting clients in managed accounts versus other products and an additional bonus could be earned. During regular meetings with advisors, supervisors praised those who gained rollovers into the managed accounts and placed advisors who failed to meet sales goals on performance improvement plans. Misleading Statements, Failed Disclosures and Deficient Policies and Procedures. TIAA Sub’s practices, not surprisingly, led to a flood of new managed accounts. The SEC found that the advisors made misleading statements when they told clients they provide “objective”, “disinterested advice” that was in the clients’ “best interest” and that they acted as “fiduciaries.” It also found that the conflicts of interest were not adequately disclosed in the firm’s Form ADV Part 2 brochure when it stated that the incentive compensation was proportionate to the effort required to recommend a product “designed to meet more complex needs” like a managed account. Finally, the SEC found that TIAA Sub’s own policies and procedures were not properly implemented. The firm did have written manuals that incorporated components of FINRA Regulatory Notice 13-45, which requires broker dealers to present clients with four options for rollovers: (i) leaving the client’s assets in the employer-sponsored plan; (ii) rolling over the assets into a self-directed individual retirement account (“IRA”) or managed IRA such as a managed account; (iii) rolling over the assets to a new employer’s plan; and (iv) cashing out the account value/taking a lump sum distribution. It also required advisors to discuss other factors, including fees and expenses relating to the rollover options. These policies were not enforced, however, when supervisors directed advisors not to follow them and some training materials encouraged advisors to avoid discussing fees and expenses with clients. Rollover recommendations regularly lacked any documentation confirming that fees and expenses about the managed program were discussed with a client or how they compared to expenses inside the employer-sponsored plans. Observations.

This is only the beginning. We believe that this action by the SEC is meant to be fair warning and that other advisors can expect the SEC to bring charges for their rollover practices.

Variable compensation is problematic. Industry practitioners have known this for some time but it is clear that paying different compensation for different advisory products brings conflicts of interest and so does paying more to roll assets outside of an employer-sponsored plan. Advisors will always be incentivized to sell what pays them more. The DOL now offers its new prohibited transaction exemption, PTE 2020-02, as guidance for how to adequately deal with compensation differentials. It remains to be seen, however, how the SEC will respond with attempts to mitigate these inherent conflicts.

Compliance manuals are not merely window dressing. It is critical that advisors maintain appropriate policies and procedures, monitor that the procedures are being followed, and keep adequate records of their findings. Firms must scour all their writings, including training manuals, firm meeting scripts and client communications, to ensure that they are consistent with their formal policies and procedures.

We encourage advisory firms to hire competent counsel and consultants to draft adequate policies and procedures, including forms that detail comparative costs and expenses.

But Wait, There’s More! Fiduciary advisors will be able to continue to rely on the DOL’s nonenforcement policy in FAB 2018-02. That release stated that the DOL will not pursue prohibited transaction claims against investment advice fiduciaries who work diligently and in good faith to comply with “Impartial Conduct Standards” for transactions that would have been exempted in the now invalidated 2016 exemptions. Similar to the SEC’s findings in this action, the DOL requires compliance with three components - a best interest standard, a reasonable compensation standard, and a bar on misleading statements to plan investors about investment transactions. We understand that the IRS will follow a similar nonenforcement policy.

None of this prevents actions by private parties, actions by federal regulators who believe there has not been a good faith effort to comply, DOL action taken as soon as the nonenforcement period expires, or further state enforcement action. We encourage all firms to prepare diligently by implementing appropriate policies and procedures and to train, train, train. The lawyers of The Wagner Law Group will be pleased to assist firms in meeting their legal and compliance obligations.

More Investors Qualify to Purchase Unregistered Securities… But What Will the Expanded Definition of “Accredited Investor” Really Change for BDs and RIAs?

2021-11-11T19:10:45Z

By Kimberly Shaw Elliott Registered representatives and investment adviser representatives may soon purchase for themselves the unregistered products they recommend to other investors, without proof of their financial resources. These financial professionals join an expanded list of other potential investors that will be considered “accredited investors” eligible to invest in unregistered securities. The market impact of this new SEC rule is unknown. Securities firms are reminded, however, that a broadened definition of who may purchase an unregistered security does not replace standard compliance evaluations of whether a potential investment is suitable for or in the best interest of a given investor, including its own representative. Background Public offerings of securities must be registered with the SEC. Potential purchasers therefore have the benefit of the detailed information contained in a prospectus as well as financial information about the issuer before a purchase is made. Some individuals and entities, known as “accredited investors,” are deemed, however, to have sufficient knowledge and expertise to participate in investment opportunities that do not have the rigorous disclosure and procedural requirements, and related investor protections, provided by registration under the Securities Act of 1933. In a rule issued August 26, 2020, the SEC significantly expanded the definition of accredited investor. Prior to the change, any determination of who is an accredited investor was based upon measures of wealth or income. Under long-standing rules, an accredited investor must have a net worth (excluding primary residence) of more than $1 million, or must have earned income above $200,000 per year ($300,000 combined with a spouse) for at least three years. The SEC believes it is time to update these older standards. “…[R]elying solely on financial thresholds as an indication of financial sophistication is suboptimal,” wrote the SEC, “ including because it may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment—and therefore fending for themselves—in a private offering, irrespective of their personal wealth. While these individuals may have fewer financial resources, they should be able to assess investment opportunity, allocate their own capital and make their own informed decisions.” To further this view, the SEC updated the definition of accredited investor to add new categories of natural persons that may qualify as accredited investors based on certain professional certifications or designations or other credentials or their status as a private fund’s “knowledgeable employee.” The revision also expands the list of entities that may qualify as accredited investors, adds entities owning $5 million in investments, adds family offices with at least $5 million in assets under management and their family clients, and adds the term “spousal equivalent” to the definition. Self-certification of the needed financial sophistication was rejected, as was any adjustment to the wealth tests. The SEC stated that it may consider changes to either in the future. The Dodd-Frank Act requires the SEC to evaluate its experience every four years. The next quadrennial review of the accredited investor definition will be due in 2023. Several of the new qualifications relate specifically to securities industry personnel. This release addresses those individuals and the firms they represent. Professional Designations Registered representatives (“RRs”) and investment adviser representatives (“IARs”) were approved as accredited investors. Essentially, the SEC ruled that if one can advise others to make a particular investment, he or she should be qualified to make that same purchase for him/herself. In a separate order issued at the same time as the new rule, three initial designations were approved to grant accredited investor status: the General Securities Representative license (Series 7), the Private Securities Offerings Representative license (Series 82), and the Licensed Investment Adviser Representative (Series 65). Persons who have passed the requisite exams and hold their certifications or designations in good standing are deemed to have sufficient sophistication to participate in investments that lack the protections afforded by registration. Even individuals who no longer work in the industry but hold registrations that have not yet lapsed may still be accredited. For example, so long as two years have not expired since a RR left the employ of a broker dealer, that individual is still registered as a Series 7 and will qualify until the registration lapses. By adding this initial list of industry professionals, the SEC is taking a measured approach. Other certifications, designations and credentials may be added after the commission gains experience with the broadened rule. Knowledgeable Employees of Private Funds Knowledgeable employees of a private fund may now also purchase that fund, regardless of wealth. A knowledgeable employee includes: 1) an executive officer, director, trustee, general partneror advisory board member, and 2) an employee of the private fund or an affiliated management person of the private fund who has participated for at least one year in investment activities of the fund. Registered Investment Advisers and Exempt Reporting Advisers Both SEC-registered and state-registered investment advisers now qualify as accredited investors. It does not matter whether the RIA is registered as a firm or an individual. The SEC rejected the notion that RIAs who are natural persons should be evaluated solely under the wealth criteria. Instead, it stated the belief that, “registered investment advisers, including those that are sole proprietorships, have the requisite financial sophistication needed to conduct meaningful investment analysis.” Included in the expanded definition of accredited investors are exempt reporting advisers. “We believe exempt reporting advisers, as advisers to private funds, have the requisite financial sophistication needed to conduct meaningful investment analysis…. Additionally, private funds themselves are institutional investors and all investors therein are presumed to be financially sophisticated.” Impact on the Market is Uncertain Exempt offerings dominate the capital market and continue to grow in absolute number and as compared to public offerings. The SEC reported that in 2019 registered offerings accounted for $1.2 trillion (30.8 percent) of new capital, compared to approximately $2.7 trillion (69.2 percent) that was raised through exempt offerings. The SEC estimates that nearly 700,000 individuals hold the Series 7. It declined to estimate how the new rule will increase the number of accredited investors but it believes that the number of newly eligible purchasers will not be significant and that their investments will have minimal effects on the private markets. The more relevant inquiry, it wrote, is whether the criteria capture the necessary level of sophistication. Similarly, the SEC was unable to estimate the impact the newly qualified RIAs and exempt reporting advisers may have on the markets Despite the difficulty in measuring potential effects of the rule, the SEC determined that it is good public policy to expand the field of potential purchasers to include those who have the financial sophistication to evaluate the risks and rewards. Impact for Firms- Continued Compliance Vigilance While not addressed by the SEC, we thought it would be helpful to add our impressions of how this new rule may impact firms’ compliance posture. For pooled investments in investment companies such as mutual funds, expanding the definition of accredited investor beyond the wealth standard may have little impact. The Investment Company Act requires that any investment company be registered with the SEC unless strict exceptions are met. One exception is for investments owned by “qualified purchasers” who have at least $5M in investable assets. Also known as “super-accredited investors”, the wealth standard for this group is far higher than the wealth requirements for accredited investors. Accredited investor status will be insufficient to qualify RRs and IARs who wish to make a purchase in these unregistered funds if those individuals are not also qualified purchasers. Similarly, RIAs themselves are now considered accredited investors under the new rule but many RIAs, even those managing significant dollars of clients’ assets, may not themselves meet the requirements to be qualified purchasers. Expanding potential purchasers to include licensed industry personnel might create new opportunities for private equity sales. Non-pooled investments are not subject to the Investment Company Act so potential investors need not meet the higher wealth standards established for qualified purchasers. Meeting accredited investor status will be sufficient for potential investors seeking to purchase an interest in a firm offered as a private placement. Any examination should not end there, however. Meeting the standard to purchase an unregistered security will not, by itself, make an investment suitable for or in the best interest of a particular investor. Firms should consider what is suitable for individuals who fail to meet the wealth standards but now qualify solely because they have the required certifications. Broker dealers and advisory firms must have compliance policies in place to consider the particular facts and circumstances of each client, including his or her financial situation and investment objectives, before approving any investment or recommendation. Not the least of these considerations is the fact that most private investments require large minimum purchases. Diversification, over-concentration and the ability to bear the financial risk must still be considered. Compliance personnel must also be aware of potential conflicts of interests that may arise if an adviser encourages purchases by customers that may increase the value of the adviser’s own investment in the same security. The new rule takes effect 60 days after publication in the Federal Register. As of the date of this release, the rule has not yet been published.

PANDEMIC and Broker-Dealer/Recordkeepers and Advisors… Chances Are, Your Business Continuity Plan Did Not Fully Address This…

2021-12-01T15:51:36Z

By Stephen Wilkes, Kimberly Shaw Elliot and Seth Gaudreau In uncertain times like these where the novel coronavirus or COVID-19 seems to be impacting everything, broker-dealers, investment advisory firms, and the recordkeepers that deal with retirement plan assets are well advised to review their business continuity planning. This should include considering whether their business continuity and disaster recovery plans (“BCPs”) are sufficiently flexible to address a wide range of possible effects of the pandemic in the United States and overseas, if applicable. These firms need to pay close attention to guidance from the regulators and focus on how their BCPs address these concerns. Although specific guidance may not apply directly to a specific line of business, taking a holistic approach can provide firms with an overall view of how the regulators want the entire industry to approach this pandemic. The Department of Homeland Security’s Cybersecurity and Infrastructure Agency (“CISA”) issued guidance identifying financial services workers as essential to continued infrastructure viability during this tumultuous time¹. Governors of various states are in accord with financial services workers deemed as essential services providers. Recordkeepers holding retirement plan assets, therefore, remain open for business. Processing that business places unfathomable strain on BCPs and creates new challenges for compliant operations. U.S. Securities and Exchange Commission (“SEC”) Chairman, Jay Clayton, recently reflected on this and the role of regulators, saying:

[T]he Commission has focused its resources on the continued orderly functioning of our securities markets—equities, fixed income securities, funds and other products―consistent with evolving health and safety directives. These efforts have centered on the continued operation of physical infrastructure, including information technology systems, and, predominantly from remote locations, continued human engagement, all the while keeping health and safety as the primary concern.²

I. Current Action Items for Service Providers We are receiving many operational questions from our financial service clients. Broker-dealers, recordkeepers, and advisors must deal with many immediate issues, such as participant distribution matters. For example, they should be considering the following right now:

Amend plans (and distribute Summary of Material Modifications) to allow for the $100,000 emergency hardship withdrawal. Given the challenges to document execution and obtaining signatures, the negative election process should be considered where available for voluntary submitter plans, prototype plans, and individually designed plans.
Call centers must be properly trained and ready to discuss loans, in-service withdraws, COVID withdrawals, and the consequences of each. Supervision must be in place to avoid crossing over from “education” to “investment advice”; in other words, there must be proper administrative support for securities recommendations.
Determine how this information will get out to participants and beneficiaries, particularly those without regular Internet access.
Use this as an opportunity when amending plan documents to simplify loan and hardship distribution provisions.
Use this as an opportunity to self-assess and review the overall recordkeeping agreement and implement modifications generally.

We are also fielding questions about offshore call centers. Recordkeepers must adjust to the closing of offshore call centers, as well as the potential closure of essential domestic locations, if a significant number of employees are required to quarantine or become ill with the virus. Firms should be considering:

Migrating overseas call center functions to the United States immediately, without violating the terms of existent overseas contracts and offshore jurisdictional employment laws.
As domestic call center infrastructure is expanded, careful consideration must be given to the securities licensing structure. The function of each call center employee may require investment adviser representative and/or registered representative qualification and registration where investment advice or effecting a securities transaction is a component of the employee’s job responsibility.
The urgency of call center expansion will require a review and implementation of up-to-date supervisory and training procedures over the call center operation.
Some may consider leveraging a third party broker-dealer firm with capacity to provide call center services, through an outsourcing or some form of shared services agreement.

II. Business Continuity Plans Well thought out BCPs can help firms stabilize their operations and cope with this dramatic change of circumstances. Firms must review and follow (as well as to modify as necessary) their BCPs. Firms should ensure that they continue to follow their standard diligence process for investments (and document compliance), even if doing so may be more challenging due to employees working remotely. Firms should also confirm that all of their operations (e.g., investing, trading, investor relations, compliance, required recordkeeping) are all functioning as anticipated under their BCPs, even if such functions are occurring remotely. During and after past crises, the SEC’s Office of Compliance Inspections and Examinations, FINRA, and the CFTC have jointly and separately reviewed the BCPs of firms, especially in the event of a problem experienced during the crisis. As part of a firm’s BCPs, they should also be paying close attention to all regulatory guidance that affects their overall operations. IV. Specific Pointers

At this point firms should have checked their BCPs to see if they expressly address pandemics or similar health issues. BCPs should include a bullet list of foreseeable risks they are designed to address, or a list of objectives that may include providing for the safety of personnel and the protection of critical data. For BCPs that do not specifically mention them already, now is the time to add procedures for pandemics, epidemics, outbreaks, and similar health-related issues reasonably likely to impact operations.
As part of the BCPs, firm compliance personnel need to make sure they have current contact information for all staff (including emergency contact information) and service providers. Firms need to be able to quickly adapt and ensure that communications with employees, clients, and investors are accurate and complete.
Firms need to monitor cloud-based systems to reduce the risk of inadequate security around mobile device management, cybersecurity, data flow, multiple wireless connections, and more.
Firms need to remind all employees that bad actors will take advantage of this outbreak and that appropriate verifications must be made before clicking on links, sending documents and, of course, transferring funds or securities.
Firms need to review all contracts, paying particular attention to the termination, indemnification, default, and force majeure provisions to have a complete understanding of what can happen if your firm or a counterparty cannot perform due to the current crisis.
Although there does not appear to be a clear time frame, firms should be prepared to operate under these conditions for at least the next 3–6 months.

IV. Responses from Regulators

SEC GuidanceAlthough investment advisers are not subject to an express business continuity rule under the Investment Advisers Act of 1940 (the “Advisers Act”), business continuity plans are an integral part of an investment adviser’s fiduciary duty to clients. The SEC has been clear that, in furtherance of this fiduciary obligation, it expects an adviser to have developed a business continuity plan as part of its policies and procedures.³ The SEC is monitoring how companies are reporting the effects and risks of COVID-19 on their businesses, financial condition, and operations and is providing guidance of the staff’s current views on an ongoing basis during the pandemic. In its most recent guidance, on March 25, 2020, Topic No. 9: Coronavirus (COVID-19), the SEC s Division of Corporation Finance addressed disclosures and other securities law obligations that companies and financial industry actors should consider with respect to the effects of COVID-19.The SEC stated that “[a]ssessing the evolving effects of COVID-19 and related risks will be a facts and circumstances analysis,” and to assist companies they provided an illustrative, but not exhaustive, list of questions to consider. In regards to BCP’s the SEC offered the following questions:
1. Have COVID-19-related circumstances, such as remote work arrangements, adversely affected your ability to maintain operations, including financial reporting systems, internal control over financial reporting, and disclosure controls and procedures? If so, what changes in your controls have occurred during the current period that materially affect, or are reasonably likely to materially affect, your internal control over financial reporting? What challenges do you anticipate in your ability to maintain these systems and controls?
2. Have you experienced challenges in implementing your business continuity plans, or do you foresee requiring material expenditures to do so? Do you face any material resource constraints in implementing these plans.
3. Will your operations be materially impacted by any constraints or other impacts on your human capital resources and productivity?

Over the past couple months, the SEC has been issuing guidance and temporary relief from various filing requirements; however, a general theme is that the SEC will need to see the process that firms used to follow the guidance and how they documented that it was necessary or appropriate for the firm to claim reliance on the relief.

The SEC has created SEC Coronavirus (COVID-19) Response, a dedicated section on its Website that addresses SEC guidance during the pandemic.

2. FINRA Guidance

Many aspects of activity taken during this crisis place firms’ systems security to the test, as well as challenge customer information protection. FINRA has already noted that, “The risk of cyber events may be increased due to use of remote offices or telework arrangements. [I]t is important that member firms remain vigilant in their surveillance against cyber threats and take steps to reduce the risk of cyber events.”⁴ Valuable, general guidance about cybersecurity is included in FINRA’s release. For small firms that are now rethinking their cybersecurity programs, FINRA has previously released its Cybersecurity Checklist, which still provides relevant guidance.⁵

There is no blanket relief to a firm’s duty to supervise. In FINRA Regulatory Notice 20-08, Pandemic-Related Business Continuity Planning, Guidance and Regulatory Relief (Mar. 9, 2020), FINRA addressed the supervisory obligations of member firms who are now faced with unprecedented operational and personal disruptions. It offers some regulatory relief and identifies areas of concern that firms may face as a result of COVID-19. It does not otherwise modify or expand FINRA’s current Business Continuity Rule (Rule 4370). FINRA maintains a dedicated COVID-19/Coronavirus section on its Website, which contains its recent guidance, including updated FAQs to address the guidance discussed in FINRA Notice 20-08, which can be found at Frequently Asked Questions Related to Regulatory Relief Due to the Coronavirus Pandemic. Here is a summary of FINRA’s guidance relating to BCPs, as well as our observations, much of which may be equally relevant to avisory firms:

1. Telework Arrangements. Member firms using remote offices or telework arrangements must be sure to establish and maintain a supervisory system that is reasonably designed to supervise the activities of each associated person while working from an alternative or remote location. Our observations Virtual Meetings. As remote workers collaborate through virtual meetings, are they protecting customer privacy? Is customer information being discussed during calls or presented on-screen? How do you account for all attendees, and do they have the right to receive the information? Who can view PowerPoints or other online material? Can it be downloaded? Home equipment. Are remote workers using a network that can be accessed by others? Is confidential information being left on home printers? How is trash, which may include confidential client information, being held? How is it being discarded? Are client lists safeguarded? Electronic Signatures. Do your contracts provide for electronic delivery of documents and for electronic signatures? This can be a great benefit when business cannot be conducted in person. If your contracts provide for E-signatures, are they being processed over compliant systems?
2. Cybersecurity. Risk of cybersecurity events may increase during a pandemic due to the use of remote offices or telework arrangements, heightened anxiety among associated persons and confusion about the virus. In order to address this increased risk, FINRA recommends: (1) ensuring that virtual private networks and other remote access systems are properly patched with available security updates; (2) checking that system entitlements are current; (3) employing the use of multi-factor authentication for those employees who access systems remotely; and (4) reminding associated persons of the cyber risks through education that promotes heightened vigilance.Our ObservationsIncreased Security Risks. As home office and branch locations are closed, who is collecting the mail? Are checks being found and timely deposited? Are checks being sent to advisors’ homes? How are requests for distributions being processed?Communicating With Customers. FINRA is also advising firms to expect an increase in customer call volumes and online account usage during a pandemic and to therefore plan accordingly. Specifically, FINRA urges member firms to review their BCPs regarding communicating with customers and ensuring that customers have access to funds and securities. For member firms with registered representatives who are unavailable to service their clients, the member firm should place a notice on its Website notifying those customers who they may contact concerning the execution of trades, their accounts, and access to funds or securities.Call Volumes. Call centers are built for anticipated call volumes and are largely staffed with associates working from centralized, brick-and-mortar locations. With market volatility, broker-dealers are receiving record numbers of calls from their clients and their representatives. This explosive volume must be handled just as workers are sent home to work remotely. Is your firm staffed for this? Many firms have redeployed workers from other departments to staff the customer service lines. Despite the disruption to other functions, this redeployment provides valuable training by giving employees front-line insight to the concerns of their customers. Others may have prearranged to outsource some services, whether domestically or offshore. Regardless of how the worker is sourced, careful consideration must be given to whether each associate is properly licensed for any duties assigned to him or her. You may be reminded of basic credentials by visiting FINRA’s registration requirements at its Individual Registration page, and its Qualification Exams page. Advertising Reviews. Good advisors do not hide from bad news and are available to their clients when needed. Are your advisors sending alerts to customers now? Have those alerts been reviewed and approved by Compliance? Can you capture and maintain a record of the advertising? Are the messages being sent to customers consistent with the firm’s carefully crafted messaging.
3. Communicating With FINRA. Firms are required to provide FINRA with emergency contact information pursuant to Rule 4370. Member firms should review their emergency contacts to ensure that FINRA has a reliable means of contacting each member. If a member firm or another person cannot contact FINRA via its usual contact due to a pandemic or other significant business disruption, they should call FINRA’s Call Center at (301) 590-6500.
4. Regulatory Filings and Responses to FINRA Inquiries, Matters, and Investigations. In the event of a pandemic, member firms may face challenges making timely regulatory filings (e.g., FOCUS filings, Form Custody filings, and supplemental FOCUS information pursuant to FINRA Rule 4524 (Supplemental FOCUS Information)) and responding to regulatory inquiries or investigations. FINRA is telling member firms that require extra time to respond to open inquiries, investigations, or upcoming filings should contact their risk monitoring analysts or the relevant FINRA department to seek extensions. FINRA may waive any late fees incurred by a member firm based on the member firm’s particular circumstance. In addition, if any data communications are disrupted, member firms should retain the relevant data until it can be transmitted to FINRA.Our ObservationsFOCUS Filings and Reduced Revenue. Most firms, whether brokerage firms or advisory firms, can expect reduced revenue during the market downtown. For fee-based advisory business, some fees are not deducted from plan assets, but are paid directly by the plan sponsors. If your firm has direct-billed fee arrangements, can the employer now afford the fees? How will your business survive on reduced revenue, caused by the double-hit of the effect of the market decline on asset-based fees as well as the inability of some companies to pay fees directly?Customer Complaints. Market declines are always followed by customer complaints, regardless of the cause. We are told that broker-dealers are already receiving record numbers of complaints. Who is reviewing them? Are all of these complaints being properly reported? Are standard firm practices being followed about evaluating and responding to those complaints? What impact may this have on the firm’s capital requirements? Is adequate errors and omissions insurance in place?
5. Qualification Examinations and Regulatory Element Continuing Education. Any affected person who has a qualifications examination or continuing education window that is due to expire is encouraged to contact FINRA regarding an extension. Please contact FINRA’s Call Center at (301) 590-6500 with any questions, or if you require additional information.
6. Military Personnel and National Guard. The declaration of an emergency in a specified area due to COVID-19 may result in some persons volunteering or being called into active military duty. FINRA Rule 1210 (Registration Requirements) provides specific relief to persons registered with FINRA who volunteer or are called into active military duty. For information on providing the required notification to FINRA, visit FINRA’s Active Military Leave Guidance Webpage.
7. Form U4/Form BR and Office Relocations. FINRA has temporarily suspended the requirement to maintain an updated Form U4 regarding office employment address for registered employees who temporarily relocate because of COVID-19. Further, FINRA also suspended the requirement for member firms to submit branch office applications on Form BR for any newly opened temporary office locations or space-sharing arrangements established as a result of recent events. FINRA is also requiring member firms to use “best efforts” to provide written notification to its FINRA Risk Monitoring Analyst as soon as possible after establishing a new temporary office or space-sharing arrangement.

V. Conclusion Most relief provisions issued to date are limited to very specific circumstances and do not yet excuse fundamental compliance practices. While the situations we currently face are new experiences, the basic framework to respond to these challenges remains unchanged. Sound compliance practices require ongoing vigilance, continued monitoring of regulatory developments, and agile responses to changing developments. Thorough records of your effort to protect your customers are key. Firms should assume that the SEC and other regulators will examine how you have handled this situation.

¹MEMORANDUM ON IDENTIFICATION OF ESSENTIAL CRITICAL INFRASTRUCTURE WORKERS DURING COVID-19 RESPONSE, U.S. Department of Homeland Security, March 19, 2020. Memorandum issued on March 19, 2020. ²See Public Statement of SEC Chairman Jay Clayton for FSOC Open Meeting (March 26, 2020).
³See U.S. Securities and Exchange Commission, Final Rule: Compliance Programs of Investment Companies and Investment Advisers, Release No. IA-4439 (February 5, 2004), https://www.sec.gov/rules/final/ia-2204.htm
⁴Cybersecurity Alert: Measures to Consider as Firms Respond to the Coronavirus Pandemic (COVID-19), Information Notice 3/26/20, https://www.finra.org/rules-guidance/notices/information-notice-032620
⁵https://www.finra.org/compliance-tools/cybersecurity-checklist