PLANADVISER - July/August 2018 - 54

compliance consult
Principal Transactions
Advisers are still fiduciaries under the 5-part test
ONE of the trickiest areas of compliance for advisers and
their supervising firms is related to principal transactions.
The Securities and Exchange Commission (SEC), Financial
Industry Regulatory Authority (FINRA) and Department
of Labor (DOL) recognize that principal transactions pose
acute conflicts of interest.
Advisers should understand that their compliance
obligations in connection with principal transactions will
depend on whether their activities are governed by the
Securities Exchange Act of 1934, Investment Advisers Act of
1940-aka the Exchange Act and the Advisers Act, respectively-the
Employee Retirement Income Security Act of
1974 (ERISA) or the Internal Revenue Code of 1986 (IRC). The
impact of these statutes and underlying regulations have
come to the forefront as firms have begun to react to the
vacatur of the DOL's fiduciary rule and related exemptions.
An adviser supervised by a broker/dealer (B/D) that
recommends an investor purchase a security in a principal
transaction is subject to the requirements of the Exchange
Act and FINRA when making these recommendations.
Therefore, an adviser must make such recommendations in
accordance with FINRA's suitability requirements in FINRA
Rule 2111 and best execution requirements in Rule 5310.
Further, Exchange Act 10b-10 requires that the firm disclose
that it sold the security as principal, as well as certain
compensation it received, while the anti-fraud provisions of
Exchange Act Rule 10b-5 require the disclosure of certain
conflicts. FINRA also requires substantial recordkeeping by
firms of principal and of riskless principal transactions.
An adviser who acts as a fiduciary for purposes of the
Advisers Act has additional responsibilities. According to
the U.S. Supreme Court in SEC v. Capital Gains Bureau, Section
206 of the Advisers Act imposes fiduciary duties on advisers.
These duties include the disclosure of material facts, avoidance
of engaging in transactions involving a conflict of
interest unless such conflicts are disclosed, determination
of suitability, best execution and loyalty.
Section 206(3) of the act specifically prohibits an adviser
from engaging in principal transactions with his clients
unless he discloses, before completion of a transaction, that
his firm is entering into it as principal and obtains consent
to proceed.
These restrictions apply to principal transactions
including those in which the adviser or an affiliate is an
issuer or underwriter. The adviser must comply with the
remaining fiduciary duty provisions of Section 206 even if
the requirements in 206(3) are met.
ERISA and the IRC place further restrictions on advisers
acting as fiduciaries with regard to ERISA-governed accounts.
Additionally, the IRC places limits on those acting as fiduciaries
for non-ERISA tax-favored accounts such as individual
retirement accounts (IRAs). Both ERISA and the IRC prohibit
a fiduciary from engaging in a self-dealing transaction or a
transaction in which the fiduciary or an affiliate receives
payments from a third party.
ERISA also prohibits fiduciaries or their affiliates from
acting on both sides of a transaction. Principal transactions
result in such prohibited transactions.
Such issues also arise when an adviser or his affiliate is
an issuer, underwriter or member of the selling group.
Under ERISA and the IRC, the adviser must comply with
prohibited transaction exemptions (PTEs). With the vacating
of the DOL's best interest contract (BIC) exemption and the
principal transactions exemption, advisers who act as fiduciaries
may have limited relief. In the interim, DOL Field
Assistance Bulletin (FAB) 2018-02 states that advisers may
continue to apply transition versions of the BIC exemption,
which allows advice fiduciaries to engage in riskless principal
transactions, or of the principal transaction exemption,
which lets them engage in principal transactions with
respect to certain securities.
Notably, the FAB is only temporary and provides only
enforcement relief from the DOL. Thus, the FAB may be
more helpful when a principal transaction involves an IRA
rather than an ERISA-governed plan.
Otherwise, there is no specific prohibited transaction
exemption that applies to principal transactions when
the adviser is a fiduciary. DOL PTE 86-128 may be read to
cover riskless principal transactions, which are more in the
nature of agency transactions. However, the DOL has not
confirmed this interpretation and is unlikely to interpret its
own exemption this broadly.
Additionally, DOL PTE 75-1 provides limited relief when
a fiduciary or its affiliate is a member of an underwriting or
selling group.
Given the lack of exemptive relief, fiduciary advisers
may find it challenging to comply with the prohibited transaction
provisions when engaging in principal transactions.
David Kaleda is a principal in the fiduciary responsibility practice
group at Groom Law Group, Chartered, in Washington, D.C. He has
an extensive background in the financial services sector. His range of
experience includes handling fiduciary matters affecting investment
managers, advisers,
broker/dealers,
insurers, banks and service
providers. He served on the Department of Labor's ERISA Advisory
Council from 2012 through 2014.
54 | planadviser.com july-august 2018 Art by Tim Bower
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