The Pension Plan Protection Act of 2006 added to ERISA a new section 408(b)(19), which provides an exemption for the “cross-trading” of securities between accounts managed by the same investment manager, subject to certain conditions. In addition, Congress provided that the U.S. Department of Labor (“DOL”), after consultation with the U.S. Securities and Exchange Commission (the “SEC”), was to issue regulations within six months of the date of enactment regarding the content of the written policies and procedures that an investment manager is required to adopt to qualify for the exemptive relief.
In February 2007 – just within the six-month deadline – DOL issued an interim final regulation, effective April 13, 2007. Statutory Exemption for Cross-Trading of Securities, interim final rule with request for comments, 72 Fed. Reg. 6473 (Feb. 12, 2007). DOL also solicited comments on a number of issues.
DOL has now issued a final regulation. Statutory Exemption for Cross-Trading of Securities, final rule, 73 Fed. Reg. 58450 (Oct. 7, 2008). The final regulation is largely consistent with the interim final rule, with a few clarifications in response to comments. DOL rejected several comments asking it to modify certain conditions to broaden the ability to utilize the exemption, finding the suggested changes to be inconsistent with the statutory language. In addition, the preamble to the final rule contains an explanation of DOL’s view on the nature of the prohibited transaction triggered by cross trading, indicating that the prohibition applies to same-manager cross trades, but may not apply to cross trades between affiliated managers.
Section 408(b)(19) provides an exemption from sections 406(a)(1)(A) and (b)(2) of ERISA—the prohibitions on purchases and sales with parties in interest and on a fiduciary acting on both sides of a transaction—for the purchase and sale of a security between a plan and any other account managed by the same investment manager. A number of conditions apply, including that the transaction be effected at the independent current market price of the security; that no brokerage commission or other remuneration be paid; that there be advance authorization of cross-trading by an independent plan fiduciary; and that the manager conduct an annual review of the cross trades documented in a written report. The exemption is only available to plans (or master trusts for related plans) with assets of at least $100 million.
Policies and Procedures Requirement
An additional requirement is that the manager adopt, and effect the cross trades in accordance with, written cross-trading policies and procedures that are fair and equitable to all accounts participating in the cross-trading program, and that cover pricing and allocation. DOL was directed to issue regulations regarding the content of these written policies and procedures .
The final regulation, which implements this condition, is designed to ensure that the polices and procedures provide sufficient information to enable a plan fiduciary to assess the manager’s cross-trading program, and to enable the manager’s compliance officer to review trades to ensure compliance with the written policies and procedures (which then must be covered in an annual report issued by the compliance officer to the authorizing plan fiduciary). The policies and procedures also must be provided to the plan fiduciary who authorizes the manager to engage in cross trades on behalf of the plan.
The content of the policies and procedures must be clear and concise, and written in a manner calculated to be understood by the plan fiduciary authorizing the cross trade. No specific format is required, but the policies and procedures should be sufficiently detailed to facilitate the compliance officer’s periodic review and determination regarding compliance.
The policies and procedures must include:
- A description of how the manager will determine that the cross trades are effected at the “independent current market price” of the security within the meaning of SEC Rule 17a-7(b) and the SEC no-action and interpretive letters thereunder, including the identity of sources used to establish such price. According to the preamble to the interim final rule, the description should contain sufficient detail to enable the compliance officer to independently determine that the cross-trade transaction was effected at the “independent current market price.”
- A statement of policy describing the criteria that will be applied by the manager in determining that execution of a securities transaction as a cross trade will be beneficial to both parties to the transaction. DOL noted that ERISA’s general standards of fiduciary conduct also would apply to the determination to cross-trade securities on behalf of a plan (explained in the interim final rule preamble to cover (1) the decision to enter into a cross trade and (2) the terms of such cross trade).
- A description of the procedures for ensuring compliance with the $100 million minimum asset size requirement. The final regulation specifies that a plan or master trust will satisfy the minimum asset size requirement as to a transaction if it satisfies the requirement upon its initial participation in the cross-trading program, and on an annual basis thereafter.
- The interim final rule had specified that the minimum asset size requirement should be satisfied on a quarterly basis. This was changed to annual in the final rule, in response to comments pointing out that many managers obtain updated information about their clients only on an annual basis.
- A statement that any investment manager participating in a cross-trading program will have conflicting loyalties and responsibilities to the parties involved in any cross trade, and a description of how the investment manager will mitigate such conflicts.
- The interim final rule had required only a description of how the manager would mitigate any “potentially” conflicting division of loyalties and responsibilities to the parties involved in any cross-trade transaction. The expansion of the requirement to include a statement regarding the conflicts was to offset the deletion of such a statement from the required disclosure to the authorizing fiduciary. DOL also deleted the word “potentially,” to reflect its position that there is an inherent conflict of interests whenever there is a common investment manager on both sides of a transaction.
- Several commenters recommended that this provision be deleted, arguing that the other policies and procedures requirements, taken together, are sufficient to mitigate any conflicts. DOL countered that sole reliance on an independent market price and objective allocation procedure would not reduce the potential for abusive practices such as “cherry picking” or “dumping,” and declined to adopt this suggestion. DOL emphasized that ERISA’s general standards of fiduciary conduct continue to apply to an investment manager’s decision to cross-trade securities on behalf of the plan, and are not affected by the relief provided by the statutory exemption.
- A requirement that the manager allocate cross trades among participating accounts in an objective and equitable manner, and a description of the allocation method(s) that will be available to and used by the manager. DOL noted its understanding that managers have relied on different systems, such as a pro rata or queue system, to effectuate an objective allocation, and recognized that there may be a number of objective systems that are appropriate for this purpose. The final regulation adds that if more than one allocation methodology may be used, there must be a description of what circumstances will dictate the use of a particular methodology.
- The identity of the compliance officer responsible for reviewing compliance with the cross-trading ??policies and procedures, and the officer’s qualifications for this position.
- DOL rejected comments that identifying the compliance officer and the officer’s qualifications would be unnecessary and burdensome, taking the view that this information could affect the authorizing fiduciary’s decision to participate in the manager’s cross-trading program.
- DOL also rejected a request to further require that the compliance officer’s compensation not be materially affected by any trading resulting from the transactions that are reviewed, finding such a matter to be beyond the scope of this regulatory proceeding. Signing the annual compliance report under penalty of perjury should provide a sufficient deterrent to ensure that the compliance officer acts independently, DOL added.
- While nothing in the regulation prohibits a compliance officer from delegating certain aspects of its responsibilities, DOL noted, the compliance officer is ultimately responsible for the compliance review under penalty of perjury.
- DOL acknowledged that nothing in the rule would preclude the compliance officer from reviewing cross trades using an appropriate sampling methodology based on the universe of cross trades effected by the manager under the exemption, provided that the sampling methodology is disclosed in the manager’s policies and procedures. DOL further noted its expectation that auditors would ensure that the sample selected is an appropriate representation of the total universe of transactions engaged in over the entire test period.
- A statement that the statutory exemption requires satisfaction of several objective conditions in addition to the policies and procedures requirement.
- A statement describing the scope of review conducted by the compliance officer.??
- The interim final rule required that the policies and procedures specifically note whether the review is limited to compliance with the policies and procedures or extends to overall compliance with the statutory exemption. Some of the commenters took the position that the compliance officer’s review should be properly limited to compliance with the policies and procedures, but that any disclosure of the limited nature of the review would suggest that the review is deficient. DOL said that disclosure of the scope of review is an important consideration for authorizing fiduciaries, and places them on notice of the extent to which they may rely on the compliance officer’s monitoring. However, to avoid implying that a review only for compliance with the policies and procedures would be deficient, DOL deleted the additional language. To ensure that authorizing fiduciaries would remain aware that other conditions to the exemption must be satisfied, DOL required an additional statement to be included in the policies and procedures to that effect (see the preceding dot point).
Some of the commenters asked DOL to make the cross-trading disclosure and other requirements under the statutory exemption as consistent as possible with SEC Rule 17a-7, the cross-trading rule for mutual funds, to reduce administrative burdens on managers. DOL declined to do so in light of the significant differences between Rule 17a-7 and the statutory exemption, given that the statutory exemption relies on an expanded role for a compliance officer and more detailed disclosure to the authorizing fiduciary to compensate for the absence of a mutual fund board of directors to perform oversight of the cross-trading activity.
The regulation requires that the advance disclosure to the authorizing fiduciary be in a document separate from any other agreement or disclosure involving the asset management relationship. The interim final rule had required that the disclosure contain a statement that the manager will have a potentially conflicting division of loyalties and responsibilities to the parties involved in any cross trade. In the interests of clarity, DOL decided not to include this in the disclosure, but to require instead that the policies and procedures, which are to be provided to the authorizing fiduciary, address the manager’s conflicting loyalties and responsibilities, and describe how the manager will mitigate such conflicts (as described above). DOL clarified in the preamble to the final rule that defining “investment manager” by reference to ERISA § 3(38) does not preclude a plan trustee from serving as an investment manager for purposes of this exemption, so long as the trustee meets the requirements of that provision and is formally appointed as an investment manager by a named fiduciary.
DOL noted as a general matter that an investment manager’s cross-trading program may also be subject to the requirements of applicable federal securities laws.
Additional Issues Raised by Comments
- Cross Trades with Manager’s Affiliates. The issue was whether the statutory exemption would cover cross trades with accounts of an investment manager’s affiliates. DOL responded that such cross trades would be beyond the scope of the statutory exemption. However, DOL also took the position that an investment manager’s exercise of authority to effect a purchase or sale of a security with another account over which an affiliate exercises discretionary authority would not, in itself, violate ERISA § 406(b)(2). Nevertheless, a violation could arise in operation if, in fact, there was an agreement or understanding between the affiliated entities to favor one managed account at the expense of another in connection with the transaction. DOL added that the exemption would cover cross trades between individual portfolio managers employed by the same investment management entity.
- Identifying Counterparties in Quarterly Reports. Another issue was whether the manager’s quarterly report to the authorizing fiduciaries detailing all cross trades executed during the quarter must include the actual names of the counterparties, which commenters said could violate confidentiality provisions in client contracts. DOL disagreed with the suggestion that the counterparties could be identified by type (e.g., mutual fund) rather than by name, finding that approach to be inconsistent with the language of the statutory exemption.
- Effect of Non-Compliance With Policies and Procedures. A question raised by the comments was whether non-compliance with the policies and procedures would invalidate the availability to the manager of the statutory exemption. DOL took the view that the exemption would be unavailable for any particular transaction not effected in accordance with policies and procedures that satisfy the statutory requirements and the regulation. The fact that the non-compliance has to be reported to the authorizing fiduciary does not relieve the manager from the responsibility to comply. However, individual instances of non-compliance would not, in themselves, render the statutory exemption inapplicable to the manager’s entire cross-trading program, provided that the other transactions meet all the requirements of the statutory exemption.
- Application of the $100 Million Requirement to Pooled Investment Vehicles. Despite comments suggesting that DOL has the authority to moderate the $100 million in assets requirement for plans invested in a pooled investment fund, DOL found such a change to be inconsistent with the statutory requirement that “each plan participating in the transaction” have assets of at least $100 million. DOL pointed out that the only exception is for master trusts containing the assets of plans maintained by employers in the same controlled group, in which case the $100 million requirement applies to the master trust. DOL noted that pooled investment vehicles comprised solely of plans with assets of at least $100 million may take advantage of the statutory exemption.
- Effective Date. Considering that investment managers may have adopted cross-trading policies and procedures and obtained authorizations in reliance on the interim final regulation, DOL made the final regulation effective 120 days after publication, or February 4, 2009. DOL added that a manager that obtained authorization prior to the effective date based on compliance with the interim final regulation would not be required to obtain re-authorization following disclosures that reflect the final regulation.
One of the concerns many managers had with the interim final rule was the requirement to acknowledge a conflict of interest inherent in cross-trading and describe how that conflict would be mitigated. Managers take the view that potential conflicts are addressed by establishing an objective process for allocation of cross-trade opportunities and for pricing the trades, which were already to be described in some detail in the policies and procedures. DOL disagreed, indicating that there is a conflict inherent in the trading decision that gives rise to the cross trade that should also be mitigated. Managers who decide to use the exemption will therefore have to develop a process that addresses this perceived conflict.
The comments asked DOL to adjust the rules of the exemption in two respects to make it more broadly available. First, they asked that the $100 million plan asset requirement not apply to every plan investor in a pooled investment fund. DOL rejected that suggestion as inconsistent with the statutory language. Therefore, it appears that this condition can be modified only through an amendment by Congress. Alternatively, DOL could grant a class exemption based on the statutory exemption with that one change. Absent a legislative or administrative change, this condition significantly limits the usefulness of the exemption for pooled funds, as many pooled funds are intended to provide diversification opportunities for plans with smaller levels of assets.
Second, the comments asked DOL to clarify that the exemption is not limited to cross trades between accounts of the same manager, but would also extend to cross trades between accounts managed by affiliated managers. Again, DOL rejected the suggestion as inconsistent with the statutory language. At the same time, however, DOL took the position that cross trades between accounts managed by affiliated managers would not violate section 406(b)(2) of ERISA, the prohibition against a fiduciary representing a party adverse to the plan in a transaction with the plan, absent an “agreement or understanding” between the affiliated entities to favor one managed account at the expense of another in connection with the transaction.
This interpretation of section 406(b)(2) is consistent with recent DOL positions that view fiduciary status as limited to the entity that is appointed, or otherwise acts, as a fiduciary, and not extending to affiliates of that fiduciary. Therefore, even though an affiliate of the fiduciary is acting for an adverse party, section 406(b)(2) should not be triggered because the affiliate is not the fiduciary itself. The question is why it makes a difference if there is an “agreement or understanding” between the fiduciary and its affiliate. The DOL position may be that when the fiduciary has such an agreement or understanding with the manager acting for the adverse party, it is as if the fiduciary itself is acting for the adverse party, triggering a section 406(b)(2) violation. While DOL focused on a benefit to the managed account, there is also the possibility that the agreement or understanding could involve a benefit to the fiduciary’s affiliate. In that case, there could be a violation of the self-dealing prohibition of section 406(b)(1) as well.
Managers intending to rely on the statutory exemption should take steps to conform their policies and procedures and their compliance process to the final regulation’s requirements by the Feb. 4, 2009 deadline.