In our last issue of Insight, Abbey Financial Markets explained some of the ways in which derivative instruments can be used to enhance pension fund investment performance and some of the advantages they have over other more traditional asset strategies.
Of course, the range of derivatives which are available to trustees and other investors is vast and continuing to develop, since it is a highly dynamic market. Broadly speaking, however, there are two main classes of derivatives: exchange traded instruments, such as futures and options, where the ‘exchange’ in question operates like any other regulated market and where the contractual documentation is standardised, and so called over-the-counter (OTC) derivative contracts, which are negotiated between two parties and are therefore bespoke instruments which are negotiated between two counterparties to the contract. Depending on the trustees’ strategy, different types of instrument may be more or less appropriate and there are, of course, economies of scale which operate in relation to the size and complexity of the investment programme being put in place. A scheme which is simply trying to protect against the risk of downside performance of a particular share or market may only need to use futures or options to create a fl oor to the price of that share or market, whereas trustees who are trying to remove the risks that are associated with interest rate volatility or infl ation in respect of their portfolio as a whole, will probably need a series of OTC swaps.
Some of the following legal points are common to both exchange-traded and OTC contracts, but the more complex issues will only relate to OTC programmes.
The counterparty’s interest: trustees’ powers Before contemplating entering into any derivatives programme, trustees obviously need to check their investment powers under the trust deed and rules of their scheme. A modern governing document will generally have very wide powers, but it may be restricted to traded options and futures, especially if the draftsman was attempting to track the Revenue’s way of characterising assets which were accepted as being held for the purposes of investment (as opposed to trading), as incorporated into what was section 659A of the Income and Corporation Taxes Act 1988.1 This may mean that the deed and rules needs to be amended if OTC contracts are to be entered into. The importance of ensuring that the trustees have the relevant power is not merely academic: counterparties to a swap or forward currency contract (and any investment manager who executes such an agreement on the trustees’ behalf) will almost invariably want to carry out their own due diligence for the trustees to be sure that the transaction is lawfully entered into (and will therefore be enforceable against the trustees).
When considering their basic powers, trustees must also be careful that they have any ancillary powers which are necessary to the way that derivative instruments work. For instance, although all OTC swaps have a nominal zero value when entered into, the fact that the price of the risks or indices on which they are structured means that the value of the swap will over time vary, so that the trustees or their counterparty (usually a bank) will either be einf or eoutf of the money (ie in notional profi t or loss). Depending on the terms of the contract, the extent to which the economic position of the parties changes will require cash or other assets to be posted with the other party as collateral. Similar price adjustment mechanisms apply to exchange-traded instruments, requiring margin or deposit payments to be made, not only to ensure that the obligations of the parties are regularly valued, but also to protect the security of the party who is ein the moneyf.
There is therefore a need to ensure that supplementary payments can be made by the trustees. This power may be contained in the deed and rules, but it will also need to be delegated as a practical matter to a fund manager or the trusteesf custodian on a dayto- day basis. As a separate point, such a delegation to an authorised person will ensure that the trustees are not engaging in emanagingf investments under the Financial Services and Markets Act 2000.
Due diligence: the effect and purpose of the derivatives programme
One would hope that trustees are unlikely to enter into any investment without going through a due diligence checklist with the schemefs advisers as to the appropriateness of the proposed investment. Since the Pensions Act 1995, the common law duties of suitability and diversifi cation of investments have been codifi ed by reference to the need for written advice from an experienced person and supplemented by the general framework of the trusteesf Statement of Investment Principles, as required by section 35 of the 1995 Act. Readers will recall that the EU Pensions Directive, as implemented by the Occupational Pensions Schemes (Investment) Regulations 2005 (the Investment Regulations) added formal requirements to ensure the security, profi tability, liquidity and profi tability of the portfolio as a whole and require that the trustees are not tying the scheme into excessive concentrations of risk or excessive counterparty exposure.2 The Investment Regulations also require that scheme assets consist predominantly of investments which are eadmitted to trading on regulated marketsf. To the extent that this cannot be satisfi ed, eg because the scheme is invested in OTC swaps, trustees are required to invest in a prudent manner.
Applying these principles to derivatives is not a problem with traded instruments: options and futures are by defi nition admitted to trading on regulated markets (although it would be possible of course to structure a bespoke contract). OTC contracts are, however, not traded, so trustees will need to be satisfi ed as to the default prudence test. Arguably, if trustees have any doubt that they are investing prudently, they would have greater fi duciary problems to consider in any event, because of the requirement to hold physical assets to support the payment obligations under the OTC contract (eg in infl ation-linked swaps, index-linked bonds and/or cash or cash-based funds), and trustees may well fi nd that they are nonetheless predominantly invested (when looking at the portfolio as a whole) in instruments that are admitted to trading.
The above requirements and restrictions of the Investment Regulations illustrate the importance of trustees being satisfi ed as to why they are using derivatives. There is of course nothing unique to derivatives about this principle: if trustees either do not understand the way in which an investment proposition is put to them or are uncomfortable with it, they clearly should not go ahead with it. The fact that trustees are required to include in their Statement of Investment Principles their attitude to risk is key here. This is complemented under the Investment Regulations by the fact that derivatives may only be used insofar as they either contribute to the ereduction of riskf or efacilitate effi cient portfolio managementf. eRiskf is not defi ned in the Investment Regulations, so is not (helpfully) limited to investment risks only. Likewise, the phrase eeffi cient portfolio managementf is not defi ned exclusively; the Regulations say that it may include ethe reduction of cost, the generation of capital or income with an acceptable, level of riskf.
Tax relief and the purpose of derivatives programmes
In what may seem like a rare example of coherence in regulation, the tax treatment of derivatives is aligned with the way that the Investment Regulations treat them. As explained above, there has long been a legal recognition that traded futures and options will be treated as held for the purposes of investment of pension schemes, thus ensuring that income and gains are tax-free. OTC contracts, on the other hand, were sometimes subject to much greater scrutiny by the Revenue. Hence, in 2003 the issue of a Tax Bulletin (No.66) setting out the Revenuefs enormalf treatment of certain swaps held by non-corporates, including pension scheme trustees, as being held for the purposes of investment was welcome. The Bulletin specifi es three alternative tests to meet this goal for derivatives:
- they must either be held to hedge risks (again undefi ned) inherent in the trusteesf existing portfolio
- they must be used to enhance the return from an existing portfolio
- they must be used to create a synthetic exposure to investments or markets in line with the schemefs normal investment policy.
Trustees should note that all of these reasons are posited on derivatives being linked to an existing strategy and/or portfolio, not a new strategy. Despite the fact that it predates A-Day, the Bulletin is still current and has not been withdrawn by HMRC.
Documentation and structures
As explained above, exchange-traded contracts are standardised and as such are non-negotiable. They will be entered into by the trustees’ investment manager (or more likely by an agent on the manager’s behalf), so the trustees will never see the contracts themselves. Because the counterparty is an exchange, eg LIFFE Euronext, the risk of the counterparty defaulting is minimal (and would only occur in conjunction with some major catastrophic incident affecting the whole market).
OTC contracts may be entered into by the manager in its capacity as agent of the trustees or by the trustees alone or by both the managers and the trustees. Whatever structure is used, there is standardised documentation in the OTC market in the form of a master agreement published by the International Swap Dealers’ Association (the ISDA).
It is outside the scope of this article to describe the ISDA documentation, but for anyone not familiar with it, the ISDA master agreement may be on the 1992 or 2002 terms, as supplemented by a schedule which varies those standard terms and various credit support documents. The style of ISDA documentation betrays the origins of ISDA, as the organisation was established to deal with the demands of a market whose participants were (and still largely are) corporate customers of banks. To UK pension fund readers, the infl uence of US banking lawyers in ISDA drafting will also be obvious; an ISDA schedule looks nothing like a UK investment management agreement for a pension scheme.
One other consequence of these stylistic differences that becomes apparent when trustees are contemplating using ISDAs is that many of the key terms of the documentation are alien. For example, a swap agreement will allow for the swap(s) to be terminated and closed out if certain levels of indebtedness occur in relation to either counterparty. That concept does not easily translate to the world of pension scheme funding. Hammonds’ Pension Fund Investment Group includes lawyers who specialise in negotiating a wide variety of derivative instruments, including swaps, so please feel free to contact us if you are considering using these types of investments.