Brokerage Agreement Boilerplate May Cost Client Their IRA

Talk to Chuck and lose your IRA?

That’s the prospect suggested by a recent bankruptcy case from ED TN  featured in the ABI Journal this month.

In a nutshell, the case held that lien granting language in the standard Merrill Lynch brokerage account agreement was a prohibited transaction with respect to an IRA. Daley, 459 B.R. 270 (E.D. Tenn. 2011)

The Chapter 7 trustee was successful in defeating the debtor’s  claim of exemption in the IRA, even though the brokerage house had never sought to exercise its right to a lien on the IRA. The bankruptcy court’s decision was upheld on appeal to the district court in September.

The Daley case was followed in a N.D. CA district court case Yoshioka, 2011 U.S. Dist. LEXIS 147483.  Yoshioka is a class action against Charles Schwab complaining that the lien creating language in the Schwab agreement put the tax exempt status of the IRA’s at risk.

Back story

These cases don’t come out of the blue, if you step back far enough.  California bankruptcy cases, inevitably involving doctors, have long held that the debtor doesn’t get an exemption in funds that are nominally held in retirement accounts, but are actually used for non retirement purposes.

In 2011, the 11th Circuit  affirmed a bankruptcy court that denied an exemption in a $700,000 self directed IRA based on the debtor’s use of the funds for investment and cash management outside of the IRA.  The prohibited transactions cost the IRA its tax exempt status and thus the exemption. Willis v.  Menotte.  The bankruptcy court decision is at 411 B.R. 783; the District Court opinion, adopted by the Court of Appeals, is at 2010 U.S. Dist. LEXIS 44773.

Thus the principles underlying the Daley decision aren’t new;  the application to an innocent and merely facial violation of ERISA is distressing.

Heads Up

I haven’t decided just what my advice to clients needs to be.  I’m certainly going to look at the terms of my own Schwab brokerage account with IRA protection in mind.

My gut reaction is to tell clients to move any IRA’s in  brokerage accounts to other custodians while this plays out.

Given the exposure to the bankruptcy community that the Daley decision has received, this issue will be with us for a while.

Image courtesy of Nemo.