In May 2004, Treasury Secretary John Snow became aware that one of his advisors had invested about $10 million of Snow's money in Fannie Mae and Freddie Mac bonds, as well as other government-sponsored housing finance companies, during a period in which Snow had been lobbying Congress to create tougher regulations for these entities. Although the Treasury Department ethics officials determined that Snow had not violated the federal conflict-of-interest rules, when the news hit the headlines, it caused the secretary great embarrassment.

The Snow scandal illustrates the need for advisors to carefully navigate the complex federal conflict-of-interest rules that are intended to prevent certain federal employees1 from allowing personal financial interests to affect official actions.2 And there may be a great deal of such advisory work in the coming months, as presidential elections usually generate a large number of federal employees — even if incumbents are re-elected.

The Ethics in Government Act of 19783 sets forth financial disclosure requirements to ensure that conflicts of interest will not arise during an employee's government service. Under the act, a “reporting individual”4 is required to file a detailed financial statement, Form SF-278, upon his nomination or appointment to a position, as well as annually throughout his government service. This statement includes information about the individual's investments and income from any trust, estate, investment fund or other financial arrangement from which income is received, or with respect to which a beneficial interest in income or principal is held by the individual, his spouse or his minor children.5 About 22,000 Forms SF-278 are filed each year for the executive branch, and this number tends to increase in the year following a presidential election.

Government employees are not only required to report, they must comply — or face criminal sanctions. The ethics act is backed up by Section 208(a) of the U.S. Code Title 18,6 which prohibits officers or employees of the executive branch from participating in an official capacity in any matter in which, to his knowledge, he, his spouse, his minor child, his general partner, an organization in which he is serving as an officer, director, trustee, general partner or employee, or any person or organization with whom he is negotiating or has any arrangement concerning prospective employment, has a financial interest.7 An employee who fails to comply with Section 208(a) is subject to imprisonment for up to five years and fines of up to $50,000 for each violation.8 In 2003, for example, there were 10 reported prosecutions.9 Section 208 does not prohibit employees from holding specific financial interests; rather, it bans them from taking official actions if such actions would affect a financial interest of the employee or certain individuals related to him.

Compliance with Section 208 generally begins when a reporting individual signs an ethics agreement vowing to take certain actions to avoid potential conflicts of interest or the appearance thereof. The agreement is customized to the individual and may provide, for example, that if he is elected or confirmed, he will resign from his position as a director, trustee, member, partner or otherwise in specific entities in which his holding a position could create a conflict of interest with his official duties. It also will set forth which stock holdings the individual will divest and should address the candidate's interest in other specific assets, such as partnerships, employee benefit plans and stock options.10

The public can access an official's Form SF-278 and any attached ethics agreement by requesting it from the Office of Government Ethics (OGE). Given that such information might be used against an individual — plus the expense and administrative inconvenience of preparing annual reports — federal employees or anyone considering government service should explore ways to limit their financial disclosure, while still complying with conflict-of-interest rules.

Section 208 and related regulations and agency rules do allow waivers and exemptions from the conflict-of-interest rules, in certain, narrowly defined circumstances. For example, Section 208 and supporting regulations permit an employee to hold certain assets that are exempt under the conflict-of-interest rules. But there are numerous drawbacks to taking this route (See “Of Exemptions, Waivers and Divestiture,” p. 22) — among them, the fact that such information still remains public. Unless an employee is authorized to participate in a particular matter because of a waiver or exemption or because the financial interest has been divested, an employee must disqualify himself from participating in a particular matter in which, to his knowledge, he or a person whose interests are imputed to him has a financial interest.11 Disqualification is accomplished by not participating in the particular matter and could, therefore, prevent an employee from participating in a number of key decisions affecting the agency where he is employed. Thus, it is necessary for employees to whom Section 208 applies to consider all available options so that they will not have to disqualify themselves from acting in a particular matter.

Often, a qualified trust is the most effective way for an employee to avoid actual or potential conflicts of interest — as well as limit disclosure.

The Ethics in Government Act created and provides for special financial disclosure requirements for qualified trusts12 — which helps an employee avoid a conflict of interest because, subject to certain limitations, the assets in that trust are not considered his financial interests for purposes of Section 208 or any other federal statute or regulation. Under qualified trust arrangements, an employee transfers his assets to an independent trustee who invests the assets and administers the trust without discussing trust matters with the employee. These trusts are called “blind trusts” because they render an employee effectively blind to the identity and nature of his actual holdings in the qualified trust. The trusts provide more flexibility and investment alternatives than does investing in exempt assets. Also, because qualified trusts are blind, the ethics act's reporting requirements, which generally mandate disclosure of the contents of a trust portfolio, do not apply in all situations.

QUALIFIED TRUSTS

There are two types of qualified trusts: the Qualified Blind Trust (QBT) and the Qualified Diversified Trust (QDT). The policy consideration for using qualified trusts is that “[i]f Government employees do not know the exact identity, nature, and extent of their financial interests, then the employees cannot be influenced in the performance of their official duties by those interests.”13

A QBT is considered to be blind only with respect to those trust assets about which no interested party (defined as the employee, his spouse, his minor or dependent children and their representatives141) has knowledge. Each original asset is a financial interest for purposes of the federal conflict-of-interest rules — until the trustee notifies the employee that a particular original asset has been disposed of, or that the asset's value is less than $1,000. Notice of such events also must be given to the OGE. A QBT is only judged blind as to assets subsequently acquired by the trustee, because the interested parties possess no information about the new trust holdings. The new assets of a QBT are not classified as financial interests of the employee.15

A QDT is different in that, from its creation, none of the assets held in it are considered to be the employee's financial interests because of restrictions on the initial assets placed in the QDT and the subsequent composition of the portfolio. The initial trust portfolio may not contain securities of issuers having substantial activities in the employee's primary area of responsibility. The initial assets also must consist of a widely diversified portfolio of readily marketable securities, and the trustee may not acquire additional securities in excess of the diversification standards.16

Although one advantage of a QDT over a QBT is that, from inception, none of the assets held in the QDT are considered the employee's financial interests; yet, if the employee sells his assets and transfers the cash proceeds to a QBT, the restrictions on initial assets transferred to a qualified trust should not apply, because the employee would be transferring cash to a qualified trust rather than the individual assets. The QBT would be considered blind as to assets purchased with cash because the employee wouldn't know what types of investments the trustee was making. With that in mind, and because a QBT imposes no limitations on the composition of the assets held in the trust, a QBT allows an employee to rebuild a portfolio of individual securities selected by the trustee in accordance with the guidance provided in the trust agreement. If the employee cannot obtain a certificate of divestiture17 stating that the sale of the assets is necessary, however, an employee may incur capital gains tax when he sells the assets.

The following rules apply to both QBTs and QDTs:

  • Independent Trustee

    The trustee of a qualified trust must be independent from the beneficiaries both in fact and appearance.18 Although the ethics act states that the trustee (and anyone else designated to perform financial duties) must be a financial institution, lawyer, certified public accountant, broker or registered investment advisor, the OGE allows only financial institutions that meet an independence test to serve as trustees of qualified trusts, except in unusual cases where compelling necessity is demonstrated to the OGE.19

  • Advisors

    Investment advisors, accountants and tax preparers employed by the trustee may be individuals, but it is unlikely that the OGE will approve of an employee's continued use of his current investment advisors rather than the trustee of the qualified trust. If the OGE permits the use of existing advisors, these advisors are subject to the same requirements for independence as the trustee. When an interested party learns about such employment, the advisor must sign the trust instrument, subject to the OGE's prior approval.20

  • Restrictions on Communications

    Most direct communication about the trust is prohibited between the trustee and the beneficiaries or their representatives. Interested parties and trustees must make all permissible communications relating to the trust in writing, with the OGE's prior written approval.

    The trustee is permitted to provide quarterly reports indicating aggregate market value of the assets, annual reports that enable the interested party to file his yearly financial disclosure statement and, with a QBT, his individual income tax return.21 Interested parties and trustees also can communicate about: (1) requests for distributions from the trust; (2) the general financial interest and needs of the interested party, such as a preference for maximizing current income or long-term capital appreciation; (3) with a QBT, directions to the trustee that the trust shall not hold a prohibited asset, and instructions to the trustee to sell all of an asset that was initially transferred to the trust by an interested party and that, because of subsequent events, creates a real or apparent conflict; or (4) with a QDT, information, documents and funds concerning sources of income other than the property held in the trust that are required by the trustee to enable the trustee to file, on behalf of an interested party, the personal income tax returns of the interested party.22

  • Tax Returns

    The trustee or his designee must prepare the trust's income tax return and cannot disclose to any interested party any information relating to the return except, in the case of a QBT, a summary of trust income in categories necessary for an interested party or his personal accountant to prepare the interested party's individual income tax return.23 The trustee or designee of a QDT must prepare the personal income tax return of any interested party in addition to preparing the trust's income tax return.24

  • Required Trust Provisions. Before a trust may be classified as a QBT or a QDT, the OGE must certify that the trust meets the requirements of Section 102(f) of the ethics act, that the certification is in the public interest, and that the certification is consistent with the policies established by the act and other applicable laws and regulations.25 A qualified trust agreement must conform to the model trust instruments that are drafted and distributed by the OGE. The OGE has approved, in limited circumstances, reasonable requests for variation from the form documents, when the act and regulations permit and sufficient reasons for the change are demonstrated. (See “Investment Language,” p. 24)

  • Filing Requirements

    First, the official creating the trust must file a copy of the trust instrument and a list of the assets transferred to the trust and their general values (specified by categories) with the OGE within 30 days of the OGE's certification of the trust.26 If additional assets other than cash are transferred to the trust, within 30 days of the transfer, the trustee must file a report identifying each asset, categorized by value.27 Within 30 days of the dissolution of a qualified trust, the trustee must file a report of dissolution and a list of the assets and value categories at the time of dissolution.28 Finally, on an annual basis, the trustee and any other designated fiduciary must file a Certificate of Compliance with the OGE by May 15 following any calendar year during which the trust was in existence.29 The books, records and tax returns of a qualified trust must be open to inspection at any time by the OGE.30

Regardless of who wins the presidential election, the coming months will see new federal employees taking action to comply with the conflict-of-interest rules. What works for one may not work for another, as the extent of the employee's personal wealth and the range of responsibilities that the employee's position entails affect his options. Anyone subject to these rules should work closely with the OGE, the federal agency's designated ethics official and experienced professionals who are familiar with the scope and operation of these provisions to design an appropriate plan for complying with the law.
The authors thank Terry L. Robbins, managing partner, Robbins & Associates LLC,Chicago, for his help with this article.

Endnotes

  1. An “employee” is an officer or employee of the executive branch of the United States or of any independent agency of the United States, a Federal Reserve Bank director, officer or employee, or an officer or employee of the District of Columbia. The term also includes a special government employee as defined in 18 U.S.C. Section 202. 5 C.F.R. Section 2640.102(b).

  2. See David S. Hilzenrath, “Snow Holdings Reveal a Surprise; Treasury Chief Sells Freddie, Fannie Bonds for a Loss,” The Washington Post, May 27, at p. E01.

  3. 5 U.S.C. App. 4. The act was modified by the Ethics Reform Act of 1989.

  4. “Reporting individual” refers to a “public filer” as defined in 5 C.F.R. Sections 2634.105(m) and 2634.202, a “confidential filer” as defined in Sections 2634.105(c) and 2634.904, a “candidate” as defined in Section 2634.201(d) and a “nominee” as defined in Section 2634.201(c). 5 C.F.R. Section 2634.105(p). A public filer includes the President, the Vice President and certain officers and employees of the executive branch. Ibid. Section 2634.202. A nominee is an individual nominated by the President to an executive branch position, the appointment to which requires Senate confirmation. Ibid. Section 2634.201(c).

  5. See 5 U.S.C. App. 4, Sections 101 and 102. See also 5 C.F.R. Part 2634, Subpart C - Contents of Reports.

  6. Subsequent references in this article to Section 208 are to 18 U.S.C. Section 208.

  7. See also 5 C.F.R. Section 2640.103(a).

  8. 18 U.S.C. Section 216.

  9. Summaries of the prosecutions reported to the Office of Government Ethics from 1990 to 2003 are available at the OGE's website, www.usoge.gov, under “Laws and Regulations.”

  10. See 5 C.F.R. Section 2634.802.

  11. 5 C.F.R. Section 2640.103(d).

  12. 5 U.S.C. Sections 102(f)(3) and (4).

  13. Ibid Section 2634.401(b)(1).

  14. Ibid Section 2634.401(a)(1)(i).

  15. Ibid Section 2634.401(a)(1)(ii), and see generally Ibid. Section 2634.403.

  16. See Ibid Sections 2634.401(a)(1)(iii) and 2634.404(b)(1). A portfolio will be widely diversified if: (1) the value of the securities concentrated in any particular or limited industrial, economic or geographic sector is no more than 20 percent of the total; and (2) the value of the securities of any single issuer (other than the U.S. government) is no more than 5 percent of the total. A security is readily marketable if: (1) daily price quotations for the security appear regularly in newspapers of general circulation; and (2) the trust holds the security in a quantity that does not unduly impair liquidity. Ibid Sections 2634.404(b)(2) and (3).

  17. See “Of Exemptions, Waivers and Divestiture” at p. 22 for a discussion of certificates of divestiture.

  18. Ibid Section 2634.401(a)(2). The regulations outline the requirements for determining whether a trustee is independent. See Ibid. Section 2634.406(a)(3).

  19. Ibid Section 2634.406(a)(2).

  20. Ibid Sections 2634.403(b)(14) and 2634.404(c)(14).

  21. Ibid Sections 2634.403(b)(8) and 2634.404(c)(8).

  22. Ibid Sections 2634.403(b)(9) and 2634.404(c)(9).

  23. Ibid Sections 2634.403(b)(7) and 2634.404(c)(7).

  24. Ibid Section 2634.404(d).

  25. Ibid Section 2634.401(c)(1)(iii). See Section 2634.405 for the standards and procedures for certifying a qualified trust.

  26. Ibid Section 2634.408(a)(1).

  27. Ibid Section 2634.408(a)(2).

  28. Ibid Section 2634.408(a)(3).

  29. Ibid Sections 2634.403(b)(11), 2634.404(c)(11) and 2634.408(b). See Appendix B to Part 2634 for the form of Certificate of Compliance.

  30. Ibid Sections 2634.403(b)(11), 2634.404(c)(11) and 2634.408(b).

Collectors' Spotlight

Himalayan Art from The Rubin Museum: “Lama,” a 14th Century ground mineral pigment on cotton, is of a seated Tibetan teacher, belonging to the Taklung (Kagyu) lineage and painted by an unidentified artist.

Himalayan Art from The Rubin Museum: A bright, delicately patterned painting of “Vishnu-Vishwarupa,” the Hindu God Vishnu, or the “preserver” of the universe, is a ground mineral pigment on cotton, from Nepal.

OF EXEMPTIONS, WAIVERS AND DIVESTITURE

Reporting individuals are allowed to hold certain types of assets, and seek waivers so they can hang onto others. All else must be divested — or, if permitted, placed in a qualified trust

The Office of Government Ethics (OGE) is the supervising ethics office for the executive branch of the federal government, and each agency has its own designated ethics official that works directly with the OGE. U.S. Code Title 18, Section 208(b)(2) provides that the OGE director has the authority to issue generally applicable regulations that exempt certain financial interests from the conflict-of-interest rules as being “too remote or too inconsequential to affect the integrity of the services of the Government officers or employees to which such regulation applies.” Employees who have these disqualifying financial interests are permitted, to the extent described in the regulations, to participate in matters affecting such interests despite the general prohibition in U.S. Code Section 208(a). These financial interests are:1

  1. Interests in diversified mutual funds, sector mutual funds, unit investment trusts and employee benefit plans.2 This exception is based on the theory that an employee's interest in any one fund is only a small portion of the fund's total assets.

  2. De minimis ownership of securities. This exception is for financial interests that arise from the ownership by the employee, his spouse or his minor children of securities issued by an entity that is affected by a particular matter involving specific parties or by a matter of general applicability, such as rulemaking.3

  3. Short-term federal government securities4and U.S. savings bonds.5

The disadvantage of the employee's investing in the permitted assets is that it may not be practical or in his financial interest. Also, the types of assets that an employee is allowed to hold must be disclosed in his annual financial reports. An advantage is that the employee can continue his relationships with his current financial and tax advisors, because there are no restrictions on who can manage his investments or prepare tax returns. Such restrictions exist with qualified trusts and may limit the involvement of the employee's current advisors.

An employee can seek a waiver for a conflict of interest under Section 208(b)(1), which allows an agency, on a case-by-case basis, to waive an employee's disqualification notwithstanding the financial interest and permit the employee to participate in a particular matter.6 A waiver requires an agency's prior determination that a disqualifying financial interest in a particular matter is “not so substantial as to be deemed likely to affect the integrity” of the employee's government service.7 Many decisions by an official are time sensitive, however, and in such cases, there may be limited time for a prior determination that an employee's financial interest in a matter will not affect his decision.

An employee must divest himself of an asset or other interest if it is not exempted, a waiver for it is not permitted, the financial interest is prohibited by statute or by an agency supplemental regulation, or if the agency determines that a “substantial conflict exists between the financial interest and the employee's duties or accomplishment of the agency's mission.”8 After divestiture, an employee is no longer prohibited from acting in the matter associated with his former financial interest.9

To alleviate the financial burden of capital gains taxes resulting from the sale of assets to comply with conflict-of-interest rules, Internal Revenue Code Section 1043 allows an employee to defer the tax on any capital gain realized from a sale of such property by rolling over the basis of such property to a subsequently purchased asset. The sale and repurchase must be made pursuant to a certificate of divestiture, and the proceeds must be reinvested within 60 days of the sale in “permitted property,”10 which is defined as “any obligation of the United States or any diversified investment fund approved by regulations issued by the Office of Government Ethics.”11 The certificate of divestiture, which is the formal document that triggers the application of IRC Section 1043, is a written determination issued by the OGE stating that the divestiture of specific property is reasonably necessary to comply with the conflict-of-interest rules or with a request by a congressional committee as a condition of confirmation.12 An employee must submit a written request to his agency's designated ethics official containing specific information about the property to be divested, which the official then submits to the OGE.13

The regulations, as amended this year, generally define the term “diversified investment fund” as a diversified mutual fund or diversified unit investment trust as defined in 5 C.F.R. Sections 2640.102(a), (k) and (u).14 The regulations provide that permitted property can include, for example, an S&P index fund, a diversified growth stock fund and U.S. treasury bonds.15

Trusts in which an employee has a beneficial interest also are eligible for deferral under IRC Section 1043. Therefore, if an employee establishes a qualified blind trust, transfers assets to it, and subsequently discovers a conflict of interest arising from an original asset that is specifically prohibited under a statute or regulation, the trustee can sell that asset and, if the requirements of Section 1043 are met, roll over the basis to permitted property.

A significant disadvantage of Section 1043 is that the permitted property acquired within 60 days of divestiture may not be property that the employee wishes to hold after his term of office ends. When the employee or trustee disposes of the permitted property at that time, the deferred gain must be recognized.
Susan M. Hughes and Thomas G. Opferman

Endnotes

  1. 5 C.F.R. Section 2640.203 contains additional exemptions that apply only in specific situations or only to employees of certain agencies. Because of their limited applicability, these miscellaneous exemptions are not discussed here.

  2. 5 C.F.R. Sections 2640.201(a), (b) and (c). See Ibid Sections 2640.102(a), (k) and (u) for definitions of the terms “diversified,” “mutual fund” and “unit investment trust,” respectively.

  3. Ibid Sections 2640.102(l) and (m). An employee may participate in a matter if certain requirements are met regarding the nature of the securities and threshold dollar amounts. Ibid. Sections 2640.202(a), (b) and (c).

  4. “Short-term Federal Government securities” are bills with a maturity of one year or less issued by the United States Treasury. Ibid Section 2640.102(s).

  5. Ibid Section 2640.202(d).

  6. The regulations set forth the requirements for waivers issued pursuant to Section 208(b)(1) and factors that the government official responsible for appointing the employee to his position may consider in determining whether a waiver is appropriate. See Ibid Sections 2640.301(a) and (b).

  7. Ibid Section 2640.301(a)(4).

  8. Ibid Section 2640.103(e). See Ibid Sections 2635.403(a) and (b) for rules about when an agency can prohibit the holding of a certain financial interest or a class of financial interests.

  9. Ibid Section 2640.103(e).

  10. 26 U.S.C. Section 1043(a). Amendments to the regulations addressing certificates of divestiture, 5 C.F.R. Part 2634, Subpart J, became effective August 27, 2004. The purpose of these amendments is to simplify and improve the existing certificate of divestiture regulations by organizing the material more logically and stating the requirements more clearly. See the preamble to the final regulations at 69 FR 44893.

  11. 26 U.S.C. Section 1043(b)(3). 5 C.F.R. Section 2634.1003.

  12. 26 U.S.C. Section 1043(b)(2). 5 C.F.R. Section 2634.1004.

  13. Ibid Sections 2634.1005(a) and (b).

  14. Ibid Section2634.1003. See supra note 2 and the related text.

  15. Ibid Section2634.1006(a), Ex. 1.

INVESTMENT LANGUAGE

A sample of what has been approved by the Office of Government Ethics

To some extent, the investment objectives for a qualified blind trust (QBT) can be tailored to achieve the employee's financial goals provided they are approved in advance by the Office of Government Ethics. The OGE, however, carefully limits the investment direction in the trust instrument based on its interpretation of the Ethics in Government Act and its regulations. The OGE has previously approved this sample investment language:

“1. The Trustee shall hold and manage the portfolios initially transferred to the Trust in a segregated account and shall invest the trust estate with the following objectives: (1) preservation of principal and moderate total return, (2) minimization of risk, and (3) positive real after-tax rates of return. Primary emphasis shall be placed on the preservation of capital.

2. The Grantor recognizes that the assets initially contributed by X to this trust are concentrated in the stock of Y. The Trustee is authorized to take the steps necessary to cause the securities to be re-registered in the Trustee's name. The Grantor further releases the Trustee from any obligation the Trustee might otherwise have to diversify the investments, and the Trustee is authorized to exercise its discretion in determining to what extent the concentrated investment in such securities should be maintained, taking into consideration all facts and circumstances which the Trustee deems appropriate, including the Grantor's basis for federal income tax purposes of the securities held by the Trustee.

3. The Trustee shall invest and reinvest the principal and any undistributed income in property of any kind in accordance with the prudent investor rule. In pursuing this strategy, the Trustee should consider both the reasonable production of income and safety of principal, with an emphasis on the preservation of the principal of the Trust. In making investment decisions, the Trustee should consider the general economic conditions, the possible effect of inflation, the expected tax consequences of investment decisions or strategies, the role each investment or course of action plays within the overall portfolio, the expected total return (including both income yield and appreciation of capital), the duty to incur only reasonable and appropriate costs, and such other factors as may be relevant from time to time.”
Susan M. Hughes and Thomas G. Opferman