Before the Pension Protection Act of 2006 (PPA) was enacted, it was generally a prohibited transaction for an investment adviser of the assets of a plan subject to ERISA (including the adviser of a fund holding ERISA plan assets), to cause this fund to engage in a transaction with another client of the adviser (or with another fund advised by the adviser). The PPA added a section to ERISA to provide a statutory exemption from the cross-trading prohibition. Effective February 4, 2009, the Department of Labor has finalized regulations that, among other matters, specify the content of the written policies and procedures required to be adopted by an adviser and disclosed to a plan fiduciary prior to the fiduciary’s authorization of the adviser’s cross-trading program.
The exemption permits the purchase and sale of a security between a fund holding plan assets and any other account (or fund) managed by the same adviser, provided all of the following requirements are met:
- The transaction is a cash-only purchase or sale of a security for which market quotations are readily available.
- The transaction is effected at the independent current market price (within the meaning of SEC Rule 17a-7(b)).
- No brokerage commission or other fee or remuneration (except customary and disclosed transfer fees) is paid in connection with the transaction.
- A fiduciary (other than the adviser or any affiliate of the adviser) for each plan participating in the transaction receives written disclosure of the conditions under which cross-trades may occur, and provides advance written authorization for the adviser to engage in discretionary cross-trades. Both the disclosure and the authorization must be in a document separate from any other written agreement of the parties.
- Each participating plan or master trust (containing the assets of plans maintained by employers in the same controlled group) must have assets of at least $100 million (although not all of such assets need to be managed by the adviser).
- The adviser must provide detailed quarterly reports of all cross-trades to the authorizing plan fiduciary, including (as applicable) the identity of each security bought or sold, the number of shares or units traded, the parties involved in the cross-trade, and the trade price and the method used to establish it.
- The adviser’s fee schedule must not be based on the plan’s consent to cross-trading and no other services may be conditioned on the plan’s consent to cross-trading.
- The adviser must adopt, and cross-trades must be effected in accordance with, written, fair and equitable cross-trading policies and procedures that must include a description of the adviser’s pricing policies and procedures and the adviser’s policies and procedures for allocating cross-trades in an objective manner among accounts participating in the program.
- The adviser must designate an individual responsible for periodically reviewing the cross-trades to ensure compliance with written policies and procedures. The designated individual must issue an annual written report no later than 90 days following the review period, signed under penalty of perjury, to the authorizing plan fiduciary. The report must describe the steps the designated individual performed during the course of the review, the level of compliance and any specific instances of noncompliance. The report must also notify the plan fiduciary of the plan’s right to terminate its participation in the program at any time.
Although fees may not be based, and services may not be conditioned, on a plan’s authorization of cross-trading, presumably the savings that result from avoiding commissions and the ability not to impact the market with the trade may make plans conclude that the cross-trading program is valuable for their investment strategy.
The exemption’s prohibition on the payment of commissions may rule out “brokered” cross-trades for ERISA-covered investors, however. The exemption is also of limited use for collective investment vehicles (including hedge funds) because 1) each investing plan must have at least $100 million in assets (or be part of a master trust with at least $100 million in assets), even if all of such assets are not invested in the collective investment vehicle; 2) plan investors cannot be induced to authorize cross-trading by reduced fees or increased services; and 3) if just one plan has less than $100 million or refuses to authorize cross-trading, then the adviser of the hedge fund cannot engage in cross-trading with that collective investment vehicle.