the Investment Company Institute
ERISA Advisory Council Working Group on
Plan Asset Rules, Exemptions and Cross Trading
Cross Trading Exemption for ERISA Plans
October 3, 2006
The Investment Company Institute, the national association of U.S. investment companies, 1 appreciates this opportunity to make recommendations about cross trading to the ERISA Advisory Council. Based on substantial experience in the mutual fund industry, cross trades can be effected with appropriate investor safeguards and save money for plans by reducing securities transaction costs. 2
The Institute has supported an active cross-trades exemption for over twenty years and we applaud Congress for taking a decisive first step to provide this relief. The Pension Protection Act, signed into law by President Bush on August 17, 2006, includes a long-needed exemption from ERISA’s prohibited transaction rules for cross trading by investment managers of certain actively-managed plans that will serve the interests of those plans and their participants. Appropriately, Congress included in the ERISA exemption relevant conditions of the SEC rule governing cross trades by mutual funds, which has proved effective in governing mutual fund cross trades for 40 years.
Our submission focuses on two courses of action we believe the Department of Labor should now take.
First, in drafting a mandated regulation under the Pension Protection Act governing the content of cross-trading policies and procedures, the Department should recognize the significant protections for plans and plan participants afforded by the specific conditions of the legislation, particularly the independent pricing requirement. The conditions address potential concerns that a manager might be tempted to use cross trades to “dump” securities or otherwise advantage one client at the expense of another. The Department’s compliance regulation should require that a manager’s policies and procedures be reasonably designed to meet the conditions of the exemption and periodically reviewed for adequacy and effectiveness of implementation. This approach is consistent with prior Department of Labor exemptions and SEC rule 17a-7, the mutual fund cross-trading rule. 3 It will achieve the legislation’s objectives, while allowing managers to develop the policies and procedures that will be most effective in their organizations and consistent with their procedures for mutual fund cross trading.
Second, the Department should use its exemptive authority to allow all plans to enjoy the benefits of cross trading. The Pension Protection Act limits the statutory exemption to plans with assets of at least $100 million. As a consequence, many plans that could benefit from the cost savings associated with cross trading cannot use the exemption. The Institute believes that plans with assets below $100 million also should be permitted to engage in cross trades, with appropriate investor safeguards.
Table of Contents
I. The Department’s Rule on the Content of Cross-Trading Policies and Procedures
The Pension Protection Act requires investment managers to adopt and comply with written policies and procedures governing cross trading, including policies and procedures on pricing and allocating cross trades objectively among the manager’s accounts. The Pension Protection Act directs the Department, after consultation with the SEC, to issue regulations on the content of the policies and procedures within 180 days after the Act’s enactment. In exercising its mandate, the Department could issue a rule that prescribes additional, specific compliance methods or a rule that requires policies and procedures to be reasonably designed to meet the conditions of the exemption and periodically reviewed for adequacy and effectiveness of implementation. We strongly urge the latter approach.
The Pension Protection Act sets forth explicit standards for cross-trading programs for ERISA clients. Plan fiduciaries must consent in advance to a cross-trading program after separate disclosure and must be able to revoke consent at any time. Consenting to cross trades cannot be a condition to engaging the manager’s services. As under Rule 17a-7, trades must be executed at the independent current market price 4 and no commission can be paid. In addition to adopting and complying with written policies and procedures on cross trading, managers must provide quarterly reports to plan fiduciaries detailing the cross trades in which the plan participated and provide an annual compliance report. The Department’s compliance rule should direct managers to adopt compliance policies and procedures that are reasonably designed to meet the conditions of the exemption.
The standard we articulate will allow managers to establish procedures that incorporate all of the requirements of the exemption, are tailored to their particular circumstances, and are consistent with their procedures for cross trades involving other types of accounts. Given the diversity of the investment management industry, to be most effective, the specific policies and procedures a manager will use to comply with the conditions of the exemption will reflect the scope and nature of that firm’s operations, including the size and organization of the firm and other internal trading rules. 5 The Department should not specify the content of policies and procedures. A one-size-fits-all approach could result in a less effective compliance regime. There are also practical considerations. Investment managers will have difficulty maintaining cross-trading programs if different procedures apply to different types of clients.
The standard we recommend is consistent with the Department’s previous guidance on cross-trading procedures. For example, the prohibited transaction class exemption for index and model-driven funds requires managers to disclose their cross-trading procedures to plan fiduciaries, but does not provide extensive detail on the content of those procedures. 6 In addition, in at least two individual prohibited transaction exemptions for cross trading involving actively-managed plans, the Department did not specify the content of the cross-trading procedures. 7 This approach is similar to the SEC’s rule on cross trading, Rule 17a-7. The rule requires a mutual fund’s board of directors to adopt “procedures for cross trading which are reasonably designed to provide that all of the conditions of the rule have been complied with.” The Institute urges the Department to take a similar approach in fashioning the parameters of the policies and procedures required under the Pension Protection Act.
We do not believe that additional Department rulemaking is necessary to implement the exemption contained in the Pension Protection Act. We recommend that the Department provide guidance through an advisory opinion or field office assistance bulletin on when managers should determine compliance with the $100 million plan size test. Investment managers may be prevented from using the exemption for plans that are not substantially larger than $100 million for the practical reason that the burdens of monitoring plan asset size on a continuous basis, and the possible consequences should the plan fall below $100 million, would outweigh the benefit of cross trading for those plans. To avoid this unfortunate result, the Department should clarify that the test should be applied at the time of the plan’s consent to enter into cross trades and annually thereafter, on a calendar or fiscal year basis.
II. The Department Should Provide Cross-Trade Relief to Plans with Assets Below $100 Million
The Pension Protection Act conditions the availability of the cross-trading exemption on compliance with specific disclosure, consent, pricing, and reporting provisions, but limits the exemption to plans with assets of at least $100 million – a standard met by only 3.9 percent of defined benefit plans. 8 In the Institute’s view, this “belt and suspenders” approach is not necessary to protect plans and their participants and denies the benefits of cross trading to far too many plans. The disclosure, consent, pricing, compliance and reporting provisions of the Pension Protection Act exemption are robust. The Department should rely on these conditions to fashion an administrative prohibitive transaction exemption for plans with assets below $100 million.
All Plans Can Benefit from Cross Trades
Investment managers enter into cross trades to benefit clients. Within an investment management firm, the decision to buy or sell a security generally is independent from the determination of how to execute the transaction. In executing a securities purchase or sale, cross trading can reduce transaction costs for clients, implement orders more efficiently, and minimize the market impact of large orders. In a cross trade, the client avoids various charges and fees associated with purchasing or selling a security on the market. Both sides of a cross trade save on commissions or benefit from lower bid/ask spreads. These cost-savings are recognized in the mutual fund industry, where mutual funds have been able to engage in cross trades since 1966. In a recent year, one mutual fund organization has reported to us savings of approximately $1.2 million in transaction costs on $500 million in cross trading of equities. Another large mutual fund organization has informed us of estimates that its funds save between $75 million and $100 million annually in commission costs through cross trading. Reduced transaction costs will result in more money actually being invested (and generating earnings) for plans and their participants.
Cross trading also eliminates duplicative efforts (e.g., selling securities piecemeal for one account while simultaneously buying similar securities for another account) and results in faster implementation of orders. 9 Moreover, when a plan’s trade involves a large amount of securities, an open market purchase or sale can disproportionately affect the market price of the security to the disadvantage of the plan. A large buy or sell order, by itself, can move the price of a security. Cross trades have little or no market impact and result in a fair price for both sides of the transaction, under the independent pricing requirement.
The $100 million limit denies the benefits of cross trading to far too many plans. According to Department of Labor statistics, the $100 million limit would prevent all but the largest 3.9 percent of defined benefit plans from cross trading. 10 Smaller plans may have less bargaining power to obtain lower commissions from brokers and potentially could benefit more from cross trading relative to larger plans. Particularly with respect to fixed income securities, smaller trades can be less efficient and have larger bid/ask spreads. Cross trading in these circumstances allows managers to achieve much lower spreads and best execution for their clients. 11
Protections Exist to Safeguard Plans Without a Minimum Asset Test
In the past, the Department had been reluctant to permit actively-managed ERISA plans to engage in cross trades because of concerns that managers might use cross trades for their own benefit or to favor certain clients. 12 The Department also has questioned whether plan fiduciaries are in a position to monitor managers in connection with cross trades. 13 We believe these concerns are overstated, even for smaller plans. Public plans, mutual funds and other institutional investors participate in cross trades with no evidence of abuse. Significantly, there have been only three enforcement cases by the SEC in the forty-year period since cross trades have been permitted for mutual funds. 14 The Department should base an administrative exemption on the conditions included in the Pension Protection Act’s exemption for active cross trades. These conditions, particularly the independent pricing requirement, together with the protections under existing law, as described below, will protect plans and their participants in connection with cross trades.
Under ERISA and the Internal Revenue Code, when a prohibited transaction exemption is granted, managers not only have the responsibility to comply with the conditions of the exemption, they also have a financial incentive. Noncompliance would result in a prohibited transaction under ERISA and, if the plan is tax-qualified, a prohibited transaction under the Internal Revenue Code. Under ERISA, if a prohibited transaction occurs, the manager would be liable for any losses to the plan and must restore any profit resulting from the transaction. Under the Internal Revenue Code, the manager would be subject to a 15 percent excise tax, and an additional 100 percent tax if the transaction is not corrected within a specified period. For nonqualified plans, the Department may assess a civil penalty, not to exceed five percent of the amount involved (or 100 percent if not corrected within 90 days of the initial assessment notice).
ERISA plans and participants also will be protected in connection with cross trades by the on-going duties imposed on investment managers under ERISA. A cross-trading exemption for ERISA plans would not relax the underlying fiduciary duty a manager owes to plan clients. Even with an exemption, a fiduciary who cross trades a security remains subject to the general fiduciary duties of loyalty and prudence. If a particular cross trade is imprudent and results in a loss to the plan, the manager could be liable to the plan for such loss.
Most ERISA plan managers are registered investment advisers under the Investment Advisers Act of 1940 and that Act provides another layer of protection for plans in connection with cross trades. Section 206 of the Investment Advisers Act, the Act’s anti-fraud provision, protects against abuses such as parking illiquid securities in ERISA plan accounts, unfair allocation of favorable cross-trade opportunities, and other forms of favoritism. The United States Supreme Court has interpreted section 206 to establish a statutory fiduciary duty for investment advisers to act for the benefit of their clients. 15
Since the Department last considered the feasibility of an exemption for active cross trades, the protections to advisory clients afforded by the Investment Advisers Act have been further strengthened. Rule 206(4)-7, effective in 2004, requires an investment adviser to adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act by the adviser and its supervised persons, to review the policies annually and to appoint a chief compliance officer, who is responsible for administering the compliance regime called for by the rule.
Fiduciaries for Plans of All Sizes Are Capable of Monitoring Cross Trades
The ability of plan fiduciaries to monitor cross trades does not depend on the size of the plan. Plan fiduciaries at many smaller employers are highly educated and financially knowledgeable, and are as capable of understanding information on cross trades as the largest and most sophisticated plans. Indeed, the Department itself has recognized that all plan fiduciaries have the capacity to review information on cross trading to determine whether the transactions are in the best interests of the plan. 16
As is always the case, plan fiduciaries who believe they cannot effectively monitor cross trades should not authorize investment managers to engage in cross trading. This approach is consistent with the Department’s guidance on other fiduciary sophistication matters. For example, the Department has stated with respect to investing in derivatives, that if a plan fiduciary does not have the requisite degree of sophistication and knowledge for a particular type of investment, the plan should not so invest. 17 Given this guidance, and the other conditions we recommend, we strongly believe it is not necessary for the Department to devise a sophistication test for an administrative exemption. Should the Department disagree, however, we would request the opportunity to work with financial industry representatives and plan sponsors to recommend an appropriate test.
* * *
The Institute strongly supports the exemption for active cross trading contained in the Pension Protection Act. However, there is important work to be done to make the exemption a useful tool for plans and to allow a wider range of plans to obtain the benefits of cross trading. We urge the ERISA Advisory Council and the Department of Labor to adopt our recommendations and those of the persons testifying on behalf of the Institute on September 20, 2006. Specifically, we call on the Department to follow the approach we recommend in exercising its rulemaking mandate in connection with cross-trades compliance policies and procedures under the Pension Protection Act. The Institute also urges the Department to use its authority to fashion an administrative exemption for active cross trades based on the conditions of the exemption in the Pension Protection Act, but not limited to plans with assets of at least $100 million. We thank the Advisory Council for allowing us this opportunity to submit our views.
1 Institute members include 8,791 open-end investment companies (mutual funds), 652 closed-end investment companies, 195 exchange-traded funds, and five sponsors of unit investment trusts. Mutual fund members of ICI have total assets of approximately $9.273 trillion (representing 98 percent of all assets of U.S. mutual funds); these funds serve approximately 89.5 million shareholders in more than 52.6 million households. Many of the Institute's 580 investment adviser members render investment advice to both investment companies and other clients. In addition, the Institute's membership includes 171 associate members, which render investment management services exclusively to non-investment company clients. A substantial portion of the total assets managed by registered investment advisers is managed by these ICI members and associate members.
2 This submission supplements the testimony of Institute members at the ERISA Advisory Council hearing on September 20, 2006 and responds to questions raised by Advisory Council members at the hearing.
3 Rule 17a-7 was issued under the Investment Company Act of 1940, which has prohibited transaction limitations similar to ERISA.
4 Under Rule 17a-7, the execution price is based on the most recent sale price on an exchange or reporting system; if there are no reported sales for the day (or if the security is not reported or traded on an exchange), the price is determined by the average of the highest bid and lowest offer for the day. The Pension Protection Act incorporates Rule 17a-7 by reference so that any modifications to that rule – for example, to update the rule to reflect changes in the securities markets – will become applicable also to the ERISA exemption.
5 The SEC has recognized the importance of flexibility in regulating compliance policies and procedures. In the final rule on compliance programs of investment companies and investment advisers, the SEC declined to enumerate specific elements that must be included in compliance policies and procedures, recognizing that “funds and advisers are too varied in their operations for the rules to impose a single set of universally applicable required elements.” 68 Fed. Reg. 74714, 74716 (Dec. 24, 2003).
6 Under PTE 2002-12, the manager must disclose the “triggering events” that will create the cross-trading opportunities, the independent pricing services that will be used by the manager to price cross-traded securities, and the methods used for determining the closing price. 67 Fed. Reg. 6614 (Feb. 12, 2002).
7 See IPTE 94-43, 59 Fed. Reg. 30041 and IPTE 89-116, 54 Fed. Reg. 53397.
8 Private Pension Plan Bulletin, Abstract of 2001 Form 5500 Annual Reports, U.S. Dept. of Labor, EBSA, February 2006.
9 Of course, if a cross-trade opportunity does not exist at the time a manager needs to buy or sell a security, the trade will be executed on the market.
10 Private Pension Plan Bulletin, Abstract of 2001 Form 5500 Annual Reports, U.S. Dept. of Labor, EBSA, February 2006.
11 Unless the Department provides the practical guidance that we recommend above on when to determine that a plan meets the size test, the number of plans that can participate in cross trades will be further restricted. That is, plans with assets that hover around $100 million likely will be precluded from engaging in cross trades.
12 See 63 Fed. Reg. 13696, 13697 (Mar. 20, 1998).
13 This concern was raised by the Department at a public hearing on active cross trades held on February 10, 2000.
14 See Gintel Asset Management, Inc. IC-25798 (Nov. 8, 2002); Back Bay Advisors, L.P. IC-25787 (Oct. 25, 2002); Strong/Corneliuson Capital Management, Inc. IC-20394 (July 12, 1994).
15 Transamerica Mortgage Advisors, Inc., et al. v. Lewis, 444 U.S. 11, 17 (1979).
16 See PTE 86-128, 51 Fed. Reg. 41686 (Nov. 18, 1986) (exemption for agency cross trading when the investment manager has discretion over only one side of the transaction).
17 Letter from Olena Berg, Asst. Sec. PWBA, to Eugene Ludwig, Comptroller of the Currency (March 21, 1996).