Introduction

On October 7, 2008, the Department of Labor (“DOL”) published a final rule implementing content requirements for disclosure required under the cross-trading exemption in Section 408(b)(19) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). The prohibited transaction rules under ERISA bar investment managers from engaging in cross-trades, i.e., the purchase and sale of a security between two managed accounts or funds managed by the same investment manager, absent an exemption. The DOL has concluded that a cross-trade constitutes a transaction between an ERISA plan and a party with potentially adverse interests, and therefore is prohibited under Section 406(b)(2) of ERISA even when executed at a reliable market quote and in the best interest of both clients. Over the years, the DOL has granted several individual exemptions for cross-trading and a class exemption for passive cross-trades (i.e., trades involving index or model-driven funds).

The Pension Protection Act of 2006 (“PPA”), enacted on August 17, 2006, provided a new exemption for cross-trades involving plans or master trusts with assets of at least $100 million. Under this exemption, an investment manager can cause its accounts to trade with each other upon the satisfaction of several conditions, including conditions modeled on the Securities and Exchange Commission (“SEC”) Rule 17a-7 under the Investment Company Act of 1940 (“ICA”) (relating to cross-trading by registered investment companies) and a condition requiring the adoption of written policies and procedures. With regard to the policies and procedures condition, the PPA crosstrading exemption did not contain explicit guidance for drafting such policies and procedures, and the DOL was directed to issue regulations regarding the content requirements. The DOL published an interim final rule in the Federal Register for public comment on February 12, 2007, and now has released the final rule.

The final rule is effective on February 4, 2009, 120 days after its publication. Investment managers that obtained fiduciary authorization to engage in cross-trades prior to the effective date, and based compliance on the interim final rule, will not be required to obtain a re-authorization, provided that they provide disclosures reflecting the final rule.

Scope

The cross-trading exemption defines “cross-trade” as the purchase and sale of a security between a plan and any other account managed by the same investment manager. In the final rule, the DOL explicitly states that cross-trades between an account managed by an investment manager and an account managed by that investment manager’s affiliate are beyond the scope of the exemption.

  • Note: The DOL indicated that a cross-trade between an investment manager and an investment manager’s affiliate would not, in itself, constitute a violation of ERISA Section 406(b)(2), but it could result in a violation of ERISA’s prohibited transaction rules if there was an agreement to favor one account over the other.

However, individual portfolio managers employed by the same investment management entity may execute cross-trades in accordance with the statutory exemption.

General Requirements

The PPA cross-trade exemption sets forth the following objective conditions for investment managers to engage in cross-trading transactions, which comprise amended ERISA Section 408(b)(19)(A) through (I):

  1. The transaction is a purchase or sale for no consideration other than cash payment against prompt delivery of a security for which market quotations are readily available.
  2. The transaction is effected at the independent current market price of the security, as is the case under Rule 17a-7(b) of the ICA.
  3. No brokerage commission, fee (except for previously disclosed customary transfer fees) or other remuneration is paid in connection with a cross-trade transaction.
  4. In advance of the first cross-trade, a fiduciary, independent of the investment manager (“independent plan fiduciary”), authorizes the investment manager to engage in cross-trading after such fiduciary has received disclosure regarding the conditions under which cross-trading may take place (with such disclosure being separate from any other agreement or disclosure relating to the asset management relationship), including the investment manager’s policies and procedures applicable to cross-trading.
  5. Each plan participating in the transaction has assets of at least $100 million, except that if the assets of a plan are invested in a master trust containing the assets of plans maintained by employers in the same controlled group, the master trust must have assets of at least $100 million.
    • Note: A plan will satisfy this requirement (the “Minimum Asset Size Test”) if the plan fiduciary certifies satisfaction of the $100 million threshold upon initial participation in the cross-trading program and on an annual basis thereafter. The DOL modified the interim rule’s requirement from verification on a quarterly basis to an annual basis for feasibility reasons.
    • Note: In the final rule, the DOL declined to extend the Minimum Asset Size Test to include pooled investment vehicles where (i) at least one plan has assets of at least $100 million or (ii) ERISA-covered plans with more than $100 million in assets hold at least 50 percent of the units of the fund. However, the DOL stated that this did not preclude pooled investment vehicles comprised solely of plans with assets of at least $100 million from using the statutory exemption.
    • Note: The DOL did not adopt the suggestion to allow cross-trades (i) by plans meeting a $50 million threshold and (ii) between plans maintained by employers in the same controlled group, so long as ERISA plans within the group met the Minimum Asset Size Test in the aggregate.
    • Note: In response to a request by a commenter for a cross-trading class exemption for plans that do not meet the Minimum Asset Size Test, the DOL took the opportunity to note that the enactment of the statutory crosstrading exemption does not foreclose consideration of future administrative relief relating to cross-trading.
  6. The investment manager provides a quarterly report to the independent plan fiduciary which details all cross-trades in which the plan participated in that quarter.
  7. The investment manager does not base its fee schedule on a plan's consent to cross-trading, and no other service (other than the investment opportunities and cost savings available through a cross-trade) is conditioned on the plan's consent to cross-trading.
  8. The investment manager has adopted, and effects cross-trades in accordance with, written policies and procedures that are fair and equitable to all accounts in the cross-trading program.
  9. The investment manager has designated and identified an individual responsible for periodically reviewing cross-trades to ensure compliance with the policies and procedures (the “compliance officer”). The compliance officer must issue an annual report no later than 90 days following the period to which it relates (signed under penalty of perjury) to the plan fiduciary who authorized participation in the cross-trading program describing the steps taken during the course of the review, the level of compliance and any specific instances of non-compliance. Such annual report shall also include notification regarding the plan’s right to terminate participation in the program at any time.

Disclosure and Reporting Requirements

The real weight of the final rule lies in the detailed explanation of the content requirements for the cross-trading policies and procedures required under ERISA Section 408(b)(19)(H). The DOL, however, also provided some clarification with respect to the other reporting and disclosure requirements of the cross-trading exemption.

A. Written Cross-Trading Policies and Procedures

The exemption requires that the investment manager must establish, and effect trades pursuant to, written cross-trading policies and procedures that are fair to all accounts participating in the cross-trading program. These policies and procedures must contain (i) a description of the manager's pricing policies and procedures; and (ii) the manager’s procedures for allocating cross-trades in an objective manner among participating accounts.

The final rule supplements this description of the policies and procedures with a mandatory checklist of provisions that must be included:

  • A statement of policy describing the criteria the investment manager will apply to determine that execution of a securities transaction as a cross-trade will be beneficial to both parties to the transaction;
  • A description of how the investment manager will determine that cross-trades are effected at the independent “current market price,” as required by ERISA Section 408(b)(19)(B), including the identity of sources used to establish such price;
  • A description of procedures for ensuring compliance with the Minimum Asset Size Test;
  • A statement that any investment manager will have conflicting loyalties and responsibilities to the parties participating in any cross-trading transaction, and a description of how the investment manager will mitigate such conflicts;
    • Note: The DOL removed the word “potentially” (which had appeared in the interim rule) from in front of “conflicting loyalties”; the DOL stated in the preamble to the final rule that it believes there is an inherent conflict of interest in these transactions.
  • A requirement that the investment manager will allocate cross-trades among accounts in an equitable and objective manner, and a description of the allocation method(s), including, where more than one method may be used, a description of the circumstances that dictate the use of a particular method;
  • Identification of the compliance officer responsible for reviewing the investment manager’s compliance, and a statement of the compliance officer’s qualifications for the position;
    • Note: The DOL retained this requirement despite objections by commentators, including the objection that notifying plan clients each time the compliance officer changes is burdensome and expensive as individuals in the position are replaced from time to time, and that these compliance responsibilities are typically a matter of corporate, rather than individual, responsibility. The DOL maintains that the benefits of this disclosure to plan fiduciaries outweigh the burdens.
  • A statement that the cross-trading statutory exemption requires satisfaction of several objective conditions in addition to the written policies and procedures requirement; and
  • A statement which specifically describes the scope of the compliance officer’s annual review.

The investment manager must furnish these policies and procedures to the independent plan fiduciary in advance of the fiduciary’s authorization to proceed with cross-trading. 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 who is authorizing cross-trading and, while no specific format is required, the information in the policies and procedures must be sufficiently detailed to facilitate the required review by the compliance officer and his or her determination that cross-trades comply with the policies and procedures.

    • Note: The DOL did not adopt modifications suggested by certain commenters that would make the disclosure obligations under the cross-trading exemption more consistent with those under SEC Rule 17a-7, noting “significant differences” between SEC Rule 17a-7 and the cross-trading exemption. As a result, investment managers who execute trades on behalf of both mutual funds and pension plans may have the administrative burden of adopting different policies and procedures for the different types of clients. The DOL also rejected the suggestion that it modify the final rule to include a safe harbor providing that the adoption of a fair allocation rule for cross-trades meeting the requirements of the ICA would automatically satisfy the requirements of the cross-trading exemption.

B. Quarterly Report

In addition to the policies and procedures, under ERISA Section 408(b)(19)(F) the investment manager must provide a quarterly report to the independent plan fiduciary who authorized cross-trading, detailing each cross-trade executed for the plan during the quarter. The final rule does not address the disclosure requirements for the quarterly reports, although the DOL provided the clarification described below in the preamble to the final rule in response to a comment.

The quarterly report must include:

  • the identity of each security bought or sold;
  • the number of shares or units traded;
  • the parties involved in the cross-trade; and
    • Note: Citing the language of the statutory exemption, the DOL did not agree to include in the final rule a clarification requested by a commentator that investment managers, due to concerns regarding confidentiality provisions in client contracts, could substitute identifications by type of counterparty (e.g., endowment, insurance account or mutual fund account) for the actual names of the counterparties in the quarterly report.
  • the trade price and the method used to establish the trade price.

C. Annual Compliance Review

The compliance officer is designated and identified by the investment manager in the policies and procedures as the individual responsible for periodically reviewing cross-trades to ensure compliance with the written policies and procedures. Following a review, the compliance officer must issue an annual report to the independent plan fiduciaries who authorized the cross-trading no later than 90 days following the period to which the review relates. This compliance officer’s annual review, signed under penalty of perjury, must include:

    • a description of the steps performed during the course of the review;
    • the level of compliance;
    • any specific instances of non-compliance; and
    • notification that the plan fiduciary has the right to terminate participation in cross-trading at any time.
  • Note: The DOL noted in the preamble to the final rule that nothing precludes the compliance officer from reviewing cross-trades using an appropriate sampling methodology that is representative of the total cross-trades effected by the investment manager over the entire test period, rather than reviewing each individual cross-trade, so long as such methodology is disclosed in the policies and procedures.
  • Note: The DOL did not adopt a suggestion that it modify the interim final rule to provide that, in reviewing the transactions of a manager registered as an investment adviser with the SEC, the compliance officer may perform his or her duties in a manner consistent with the SEC rules regarding the role of a chief compliance officer under the Investment Advisers Act of 1940 and the ICA, specifically noting the differences between the role of such a chief compliance officer under SEC Rule 38a-1 of the ICA and the role of a compliance officer under the cross-trading exemption.

Consequences of Non-Compliance

The DOL confirmed in the preamble to the final rule that this exemption is unavailable for transactions not effected in accordance with the mandated cross-trading policies and procedures. The DOL noted that while the reporting by the compliance officer of individual instances of noncompliance provides notice to the plan fiduciary, such reporting does not excuse an investment manager from its responsibility to comply with the conditions of the cross-trading exemption. Nonetheless, individual instances of non-compliance would not, in and of themselves, result in inapplicability of the exemption to the investment manager’s entire cross-trading program, provided that conditions of the exemption were satisfied in connection with the other cross-trading transactions.