AN ERISA COMPLIANCE HANDBOOK
FOR ASSET MANAGERS
Updated November 2019
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TABLE OF CONTENTS
Introduction ..................................................................................................................... 3
Basics
CHAPTER 1: When Does ERISA Apply? ........................................................................................ 4
CHAPTER 2: Fiduciary Duties ..................................................................................................... 7
CHAPTER 3: Prohibited Transactions ........................................................................................... 9
Qualifications
CHAPTER 4: QPAM Exemption .................................................................................................. 11
CHAPTER 5: Alternatives for Non-QPAMs ................................................................................... 15
CHAPTER 6: Non-U.S. Assets ................................................................................................... 17
CHAPTER 7: Fidelity Bonds ...................................................................................................... 18
Documentation
CHAPTER 8: Client Intake and Subscriptions .............................................................................. 21
CHAPTER 9: Investment Management Agreements ...................................................................... 23
CHAPTER 10: Prime Brokerage and Derivatives ........................................................................... 25
Client Relations
CHAPTER 11: Reporting and Disclosure ..................................................................................... 27
CHAPTER 12: Gifts and Entertainment ....................................................................................... 31
Transactions
CHAPTER 13: Trading Basics .................................................................................................... 34
CHAPTER 14: Affiliated Brokers ................................................................................................ 36
CHAPTER 15: Affiliated Underwriters ......................................................................................... 37
CHAPTER 16: Affiliated Funds .................................................................................................. 38
CHAPTER 17: Cross-Trades and Other Conflicts of Interest ........................................................... 39
CHAPTER 18: Foreign Exchange ................................................................................................ 41
CHAPTER 19: Asset-Backed and Mortgage-Backed Securities ....................................................... 42
CHAPTER 20: ERISA-Restricted Securities ................................................................................. 43
CHAPTER 21: Corrections ......................................................................................................... 45
Appendix
Parties in Interest Diagram .................................................................................................... 48
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Introduction
This is the 2019 revised and updated edition of Ropes & Gray’s ERISA Compliance
Handbook for Asset Managers. Like the original Handbook, this new edition is intended
to familiarize managers of U.S. private pension assets with the basic rules and requirements
of ERISA and help them make the best use of their ERISA compliance resources.
One purpose of this Handbook is to serve as a reference guide for specific situations
governed by special rules under ERISA. The objective is to provide a practical resource
that can be taken o the shelf as circumstances create a need for information regarding
compliance with ERISA. A further purpose of this Handbook is to encourage the adoption
and implementation of robust ERISA compliance policies and procedures. To facilitate the
adoption of appropriate policies, this Handbook includes “Sample Compliance Policy”
language at the end of many chapters, set o in a separate text box. Of course, to be useful
in reducing compliance risk, a manager’s policies and procedures should be carefully
tailored to its business and operations and regularly reviewed to ensure they reflect
current business needs. Legal counsel should be consulted when adopting or reviewing
compliance policies and procedures.
The first Section of this Handbook, “Basics,” reviews basic rules governing fiduciary conduct
under ERISA and discusses the methodology for determining when you are managing
ERISA plan assets. The next two Sections, “Qualifications” and “Documentation,”
address standard requirements for a manager that undertakes to manage ERISA plan assets
and customary documentation a manager should have in place before accepting ERISA
plan assets for management. The fourth Section, “Client Relations,” details reporting and
disclosure requirements in connection with the relationship between a manager and its
ERISA clients and explains rules that apply to gifts and entertainment provided between a
manager and its ERISA clients. The fifth Section, “Transactions,” explains rules that apply
to specific transactions and to transactions involving specific assets.
Although every eort has been made to reflect current guidance on key issues, new
guidance appears on a regular basis. We advise the readers of this Handbook to continue
to watch for developments in this area.
The following Ropes & Gray partners are responsible for creating and maintaining this Handbook:
Bill Jewett: +1 617 951 7070 | [email protected]
Josh Lichtenstein: +1 212 841 5788 | [email protected]
If you have particular questions regarding the content in this Handbook, please contact any of the above or
your usual Ropes & Gray advisor.
Communicating with Ropes & Gray LLP or a Ropes & Gray lawyer does not create a client-lawyer
relationship. The ERISA Compliance Handbook is intended to be used for informational purposes only.
It is not intended to be and should not be relied upon as legal advice with respect to any particular set of facts.
© 2019 Ropes & Gray LLP. All rights reserved.
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Basics
CHAPTER 1
When Does ERISA Apply?
A threshold condition for an investment or an account to be subject to ERISA is whether a
“benefit plan investor,” as defined in ERISA, is involved. “Benefit plan investors” include:
n
Employee benefit plans subject to ERISA (and related trusts), such as pension plans,
401(k) plans and Taft-Hartley (multiemployer) plans, but not:
–
governmental plans and public retirement systems, or
–
non-U.S. plans and pension systems, or
–
church plans, unless a special election has been made to be subject to ERISA.
n
IRAs and other plans that are not subject to ERISA but that are subject to section 4975
of the Internal Revenue Code (the “Code”).
n
Entities such as collective funds, group trusts, or insurance company general or separate
accounts that are deemed to hold plan assets by reason of investments in the entity by
benefit plan investors, as described below.
A client account will be subject to ERISA if the client is a “benefit plan investor” that is
subject to ERISA. However, if the only benefit plan investors in a client account are IRAs
or other nonemployer-sponsored plans or accounts that are subject to the prohibited
transaction rules under Section 4975 of the Code, but not to Title I of ERISA, then that
client account will be subject to the prohibited transaction rules, but not to the additional
requirements of ERISA.
As noted above, entities such as collective funds likewise can be subject to ERISA. If a
“benefit plan investor” invests in any pooled investment vehicle, then, unless one or more
of the exceptions described below apply, the underlying assets of the fund are deemed
to be “plan assets” for purposes of ERISA, as though an undivided interest in each asset
were held by the benefit plan investor. In that case, if any benefit plan investor is subject to
ERISA, the fund itself becomes subject to ERISA, and the fund’s manager (or, as applicable,
its general partner, managing member, trustee, adviser or similar entity) becomes an ERISA
fiduciary with respect to the assets attributable to investors that are subject to ERISA.
A benefit plan investor’s investment in an entity will cause the assets of the entity to be
treated as plan assets unless one or more of the following exceptions apply:
n
Interests in the entity constitute a “publicly oered security”— generally, a freely
transferable security that is part of a class of securities that is widely held and registered
under Section 12(b) or (g) of the Securities Exchange Act. This exception eectively
requires a U.S. listing, so publicly listed companies outside of the United States cannot
rely on this exception.
Note: This can make it challenging for ERISA plans and IRAs to invest in non-U.S.
exchange-traded funds, including UCITS.
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n
The entity is an investment company registered under the Investment Company Act of
1940 (e.g., a mutual fund, but not a Business Development Company).
n
The entity is an “operating company” because it is primarily engaged, either directly or
through majority-owned subsidiaries, in the production or sale of a product or service
other than the investment of capital (e.g., the entity’s primary business is conducted
through a majority-owned manufacturing company).
n
The entity is not itself an operating company but qualifies as either a “venture capital
operating company” (VCOC) or a “real estate operating company” (REOC). To qualify
as a VCOC or REOC, the entity would need to invest primarily in operating companies
(in the case of a VCOC) or managed real estate (in the case of a REOC), and would need
to obtain and exercise management rights with respect to those investments.
n
Less than 25% of the total value of each class of equity interests in the entity is held by
benefit plan investors, in which case participation by benefit plan investors is treated
as not “significant” and is disregarded for purposes of determining whether the entity
holds plan assets. The Department of Labor has not issued guidance on what constitutes
a separate “class” of equity for this purpose, so ERISA counsel should be consulted
in any doubtful cases. Moreover, various technical rules apply in determining whether
benefit plan investor participation is significant. Notably, for purposes of applying this
25% test, interests held by the manager or its aliates are excluded from the calculation,
unless the manager or aliate is itself a benefit plan investor. The determination of who
an aliate is can be highly fact-dependent, so care should be given in applying this
aspect of the 25% test.
The requirement to exclude capital of or under the control of the manager and its aliates
for purposes of the 25% test can create diculty when a fund is structured as a master-
feeder fund where multiple feeder vehicles all invest into the master fund and each vehicle
is controlled by an aliate of the manager. This type of structure is common if tax-
exempt or non-U.S. investors and taxable U.S. investors are all permitted to invest in a
strategy. If the manager has discretion to choose how the feeder vehicles are invested, then
there is an argument that the feeder funds should be treated as being under the control of
the master fund manager or its aliate, which would require the master fund to calculate
the 25% test based on the direct investments into the master fund and the benefit plan
investor money invested into the feeder funds. In practice, this would cause many funds to
be treated as being subject to ERISA despite those funds having sucient third-party non-
ERISA capital to pass the 25% test on an aggregated “look through” basis. To address
this concern, many funds are structured as “hardwired” master-feeder funds where each
feeder fund is required to invest only into the master fund. Please note that hardwiring is a
market-based practice and there is no statutory or Department of Labor guidance on this
topic, so funds normally try to adhere to market standards when structuring a hardwired
fund. These market standards are constantly evolving based on commercial trends and
developments under other laws, so ERISA counsel should be consulted before launching
a new hardwired structure based on previous documents.
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A client cannot elect in its investment management agreement or subscription documents
to be subject to ERISA, although governmental pension systems and certain other investors
that are not benefit plan investors frequently ask to be treated, for various purposes, as
if they were subject to ERISA. A fund, likewise, cannot elect to be subject to ERISA—
it either is or isn’t, as a matter of law. It is not uncommon, however, for a manager
to decide to operate a fund as though it were subject to ERISA, to ensure compliance
in case the fund becomes subject to ERISA and to avoid the need for continual testing
to see if participation of benefit plan investors at any given time is “significant.” It is
also common for union-sponsored “Taft-Hartley” multiemployer plans to request that a
manager act as an ERISA fiduciary when the plan invests into a fund that is not subject to
ERISA. Care should be given in negotiating the language for any such acknowledgement,
since a contractual agreement can bind a manager to an ERISA-like standard of care but
cannot actually make a manager take on ERISA fiduciary status. In all cases where a
manager elects by contract to take on ERISA-based fiduciary responsibilities with respect
to a fund that is not expected actually to be subject to ERISA, it is advisable to limit these
contractual undertakings to the standard of care, and not to agree to comply with ERISA’s
prohibited transaction rules or other requirements. In particular, it would be dicult for
a manager to comply with a contractual version of the ERISA prohibited transaction rules
when a fund is not subject to ERISA, because the prohibited transaction exemptions that
apply under ERISA would not be available as a technical matter.
SAMPLE COMPLIANCE POLICY
ERISA Status
Responsibilities for accounts
Each person who participates in the management of a client account is responsible for knowing whether
the client is an ERISA client and should be aware of the potential consequences for the person and the
Firm. If you do not know whether a client is an ERISA client, please consult with the Chief Compliance
Officer.
Responsibilities for funds
The Chief Compliance Officer is responsible for monitoring the level of investment by benefit plan in-
vestors in the funds or confirming the availability of one or more exceptions under the plan asset rules.
Monitoring of benefit plan investor participation percentages should be done in connection with each new
investment, redemption, or transfer of an interest in a fund.
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CHAPTER 2
Fiduciary Duties
A manager of ERISA plan assets is a fiduciary with respect to those assets and must satisfy
ERISA’s fiduciary standards, which are generally regarded as the highest fiduciary standards
under U.S. law. This means that:
n
The manager must act solely in the interest of the ERISA investor’s participants and
beneficiaries. For example, the manager cannot, acting in its fiduciary capacity, use plan
assets to benefit its other clients, and cannot benefit its other clients at the expense of an
ERISA investor or a fund holding plan assets.
n
The manager must act prudently with respect to decisions aecting the plan—that is,
with the care, skill, prudence and diligence under the circumstances then prevailing that
a prudent person acting in a like capacity and familiar with such matters would use. This
is often referred to as a “prudent expert” standard.
n
The manager must diversify the plan assets under its management so as to minimize the
risk of large losses, unless under the circumstances it is clearly prudent not to do so.
n
The manager must act in accordance with the documents and instruments governing the
plan insofar as those documents are consistent with ERISA.
ERISA clients will typically make a formal appointment of the manager and require that
the manager acknowledge in writing that it is a fiduciary, so that they will have properly
delegated their fiduciary authority to an “investment manager” as defined in ERISA section
3(38) and so that the manager will be able to use the QPAM Exemption (see Chapter 4).
Unless a named fiduciary has properly delegated its authority to the investment manager
and continues to ensure that the delegation is appropriate, the named fiduciary will remain
liable as a “co-fiduciary” for losses caused by the manager’s breach of its fiduciary duties.
ERISA imposes a few other technical requirements on fiduciaries managing plan assets:
n
The manager must be bonded under a fidelity bond in an amount determined according
to the value of the assets of each plan with assets under management (and whether
the plan holds employer securities). A manager should confirm that any fidelity bond
obtained clearly covers third-party ERISA plans for which the manager is responsible
(certain bonds only apply to the purchaser’s own plans). See Chapter 7 for further details.
n
An account or fund that holds plan assets may not indemnify the manager for any breach
of the manager’s fiduciary duties. A fiduciary may be indemnified or insured outside the
plan, however, including by the plan sponsor.
n
The manager must maintain the “indicia of ownership” of the assets being managed
within the jurisdiction of the U.S. district courts, with certain exceptions. This means that
if the fund intends to invest internationally, certain structural considerations may need to
be taken into account. See Chapter 6 for further details.
“Prudence is process” is an old adage among ERISA practitioners. This means that the
best way to demonstrate that a manager has acted in accordance with ERISA’s fiduciary
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SAMPLE COMPLIANCE POLICIES
Fiduciary Duties
Exclusive Benefit
The Firm’s Compliance Department will review each ERISA account at least annually and more frequently
as appropriate to determine whether investment decisions are being made without consideration of
benefits to the portfolio manager or third parties.
Prudence
The Firm should communicate periodically with each ERISA client regarding the particular needs of the
ERISA plan, such as liquidity requirements, and should retain all records of such communications. The
Firm retains all internal written memoranda relating to investment analysis or recommendations and other
records of meetings where particular investments are discussed, and other documentation relating to
investment decisions. The Firm’s Compliance Department will review each ERISA account at least an-
nually (and more frequently, as appropriate) to determine whether investment decisions are being made
with the care, skill, prudence and diligence that a prudent person acting in a like capacity and familiar
with such matters would use under the circumstances in the conduct of an enterprise of a like character
and with like aims.
Diversification
Client Intake will request an agreement from each ERISA client that the Firm is responsible for managing
only a portion of the ERISA plan’s assets and that the client will be solely responsible for overall diversifi-
cation of the ERISA plan’s assets. The Firm will document any specific guidelines regarding diversification
of each ERISA account. For accounts that are highly concentrated in a particular security or industry, the
Firm will document those weightings and discuss these findings with the portfolio manager.
Plan Documents
Client Intake will request copies of all relevant plan documents. The plan documents will be retained and
reviewed at least annually (and more frequently, as appropriate) to determine whether the plan’s portfolio
is being invested in accordance with the plan documents. Client Intake will also request from each ERISA
client a representation that the powers and duties of the Firm set forth in the investment management
agreement are consistent with the governing plan documents. Each account will be reviewed at least
annually (and more frequently, as appropriate) to determine whether investment decisions are being
made in conformity with the client’s investment objectives and any investment restrictions as stated in
the client agreement.
Bonding
The Compliance Department will review the Firm’s fidelity bond at the outset of each ERISA client
engagement and annually to confirm adequacy of coverage. Where coverage is agreed to be provided
under the bond of the ERISA client, the Compliance Department will review the bond to determine that
the Firm is named as an insured and that the coverage is satisfactory.
standards is to establish compliance policies and procedures and to maintain robust
documentation of how those policies and procedures were followed. Any policies or
procedures should be reviewed on a periodic basis to ensure that they remain appropriate
in light of changing market practices and conditions. Care should also be given to written
communications regarding ERISA accounts, including emails.
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CHAPTER 3
Prohibited Transactions
Rules governing “prohibited transactions” are set forth in Sections 406, 407 and 408
of ERISA and Section 4975 of the Code. The regulatory scheme surrounding prohibited
transactions is based on (i) broad prohibitions coupled with (ii) conditional exemptions.
Accordingly, many ordinary course arrangements are swept up in the prohibited transaction
definitions, but are permitted under applicable exemptions that require satisfaction of a
variety of conditions.
Most prohibited transactions are subject to penalty taxes—initially, 15% of the amount
involved for each year that the transaction continues. This tax is imposed on the person
dealing with the plan, which may be the manager or a third party on the other end of a
trade. If the tax is imposed on another person, the manager might nevertheless be subject
to liability by reason of indemnification or other contractual obligations. This tax regime
requires self-reporting and payment. Failure to pay the required taxes and correct the
prohibited transaction can result in an additional tax of 100% of the amount involved.
Additionally, a fiduciary that is involved in a prohibited transaction is required under
ERISA to take action to correct that prohibited transaction, which may involve disgorging
fees or otherwise making payments to the plan to make it whole. Plans involved in non-
exempt prohibited transactions are required to publicly disclose them on their annual
reports (Form 5500).
Party-in-Interest Transactions
A fiduciary that manages ERISA assets may not—unless an exemption applies—use those
assets to engage in a sale or exchange, leasing of property, loan or extension of credit,
or furnishing of goods, services or facilities with any “party in interest” to an ERISA
plan with an interest in those assets. A “party in interest” with respect to an ERISA plan
includes any fiduciary of the plan, any person providing services to the plan, any employer
whose employees are covered by the plan and any of certain aliates. A chart showing
the complete array of potential parties in interest can be found in the Appendix. Party-in-
interest transactions are determined on a “strict liability” basis.
Self-Dealing Transactions
A fiduciary may not—again, unless an exemption applies—allow plan assets to be
transferred to or used by or for the benefit of itself or any person (such as an aliate) in
which the fiduciary has an interest that could aect the exercise of its best judgment as
a fiduciary. Moreover, a fiduciary may not, absent an exemption, stand on both sides of
a transaction involving plan assets, whether acting for itself or for client accounts. This
generally prohibits cross-trades, including most rebalancing and warehousing transactions.
A fiduciary also may not receive payments from third parties in connection with a
transaction involving plan assets, again, unless an applicable exemption is available. The
determination of whether a transaction is a self-dealing prohibited transaction (other than
a cross-trade) must be made based on the prevailing facts and circumstances. Under ERISA
section 408(c)(2), a fiduciary will not be treated as having breached these prohibitions on
self-dealing if it receives reasonable compensation for services rendered.
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SAMPLE COMPLIANCE POLICY
Employer Securities
All Client Intake documents require ERISA clients to identify all employer securities and to state whether
or not they are “qualifying employer securities.” The Firm will not invest more than 10% of the assets of
any ERISA account or plan asset fund in identified employer securities. Client Intake will forward CUSIPs
for all identified employer securities to Compliance for correlation with the appropriate account’s or fund’s
compliance obligations matrix. Compliance and portfolio managers will be responsible for monitoring
investments in such securities.
Employer Securities
It is prohibited for an ERISA plan to acquire “employer securities” or “employer real
property” except in accordance with ERISA section 407(a). Employer securities are
securities issued by an employer of employees covered by a plan or by an aliate of the
employer, and employer real property is real property (and related personal property)
leased to such an employer or aliate. ERISA section 407(a) prohibits a plan from
acquiring employer securities that are not “qualifying employer securities,” defined to
include stock and certain marketable obligations. Moreover, generally, even qualifying
employer securities may not be acquired if, immediately after the acquisition, the aggregate
fair market value of the employer securities held by the plan exceeds 10% of the fair
market value of the plan’s assets. These prohibitions can be particularly challenging for
union-sponsored Taft-Hartley multiemployer plans. ERISA clients may request assistance
from managers in abiding by these restrictions, and managers may require clients to
provide lists of restricted securities to assist with this compliance.
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Qualifications
CHAPTER 4
QPAM Exemption
The QPAM Exemption (Prohibited Transaction Class Exemption 84-14) is a status-based
class exemption that enables qualifying registered investment advisers, banks, savings and
loan associations, and insurance companies to engage in a wide range of transactions with
parties in interest. To be in a position to manage ERISA assets, it is generally helpful to qualify
as a “qualified professional asset manager,” or QPAM, and to satisfy the other conditions for
using the QPAM Exemption.
The QPAM Exemption prescribes two sets of rules: one establishing the requirements for
becoming a QPAM, the other limiting the transactional settings in which the exemption will
apply. This summary focuses on the requirements as they apply to registered investment
advisers. In brief summary, the requirements are as follows:
1. The manager must meet tests for assets under management and shareholder equity.
2. The party in interest cannot have certain types of authority over the manager.
3. The plan must not make up more than 20% of the manager’s assets under management.
4. The manager must make the decision to enter into the transaction.
5. The party in interest cannot be the manager or a person “related” to the manager.
6. The terms of the transaction must be at arm’s length.
7. The manager and its aliates must not have done certain disqualifying acts.
A more detailed discussion of each requirement follows below.
1. The manager must meet the definition of a “QPAM” at the time of the transaction or, in
the case of a continuing transaction, at the time the transaction is entered into or renewed.
This means that, at the relevant times, a manager that is a registered investment adviser:
– Must have more than $85,000,000 of total client assets under its management and
control as of the last day of its most recent fiscal year. The timing of the test means
that a new manager cannot qualify as a QPAM until after its first year closes.
– Must have shareholders’ or partners’ equity, as shown in the most recent balance
sheet prepared within the two years immediately preceding the transaction, in
accordance with GAAP, in excess of $1,000,000 or an unconditional guarantee by
an aliate with more than $1,000,000 in equity of payment of all the manager’s
liabilities.
– Must have acknowledged in a written management agreement that it is a “fiduciary”
with respect to the relevant ERISA clients.
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2. At the time of a transaction (or when the transaction is entered into or renewed, in the
case of a continuing transaction), neither the party in interest on the other side of the
transaction nor any of its “aliates” (defined below) can have the authority to:
– Appoint or terminate the manager as a manager of the plan assets involved in the
transaction (including, for example, by acquiring or redeeming an interest in a fund
managed by the manager); or
– Negotiate the terms of a management agreement with the manager (including
renewals or modifications) on behalf of the ERISA client with respect to the assets
involved in the transaction.
However, these restrictions do not apply if there are two or more plans in a fund
and the assets of the investing plan, together with assets of other plans of the same
employer and aliates, account for less than 10% of the total assets of the fund. This
means that a fund’s manager will generally have to inquire into who has investment
authority over an ERISA investor’s assets only if the investor holds a 10% or more
interest in the fund. For purposes of these rules, an “aliate” of a party in interest
includes, among others:
–
any person directly or indirectly, through one or more intermediaries, controlling,
controlled by or under common control with the party in interest;
–
any corporation, partnership, trust or unincorporated enterprise of which the party
in interest is an ocer, director, or 10% or more partner;
– any director or employee who earns 10% or more of the wages paid by the party in
interest or who has direct or indirect authority, responsibility or control regarding
the custody, management or disposition of plan assets.
This condition—sometimes referred to as the “hire/fire” condition or the “power of
appointment” condition—is generally the most challenging for managers to be certain
they have satisfied. While in most cases they will know the identity of the authorized
person responsible for placing a plan’s assets under their management, they will not
necessarily know the identity of all of that person’s aliates, particularly if the person
is aliated with a major financial institution. In certain situations, responsibility for
compliance with this condition is contractually split between the manager and the
counterparty, who may be in a better position than the manager to determine whether
it has aliates with “hire/fire” power over the assets being managed. In general,
managers are most concerned with knowing the identities of any financial institutions
(such as banks) that have hire/fire authority, but the broader net of aliates may be
important to certain funds, such as direct lending funds that may need to avoid lending
to any aliate of an entity with hire/fire authority.
3. The assets of the plan in question and all other plans of the same employer and its
aliates must represent no more than 20% of the total client assets managed by the
manager. In this context, an employer’s “aliate” means only a person directly or
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indirectly, through one or more intermediaries, controlling, controlled by, or under
common control with the employer. This limitation is designed to ensure that a
QPAM is not so beholden to the plan whose assets are under management that it lacks
independence. A manager will not be prohibited from acting as a QPAM with respect
to plans that make up 20% or less (determined as described above) of a manager’s
assets, which means a manager may be able to act as a QPAM with respect to some
clients but not others.
4. The terms of the transaction must be negotiated by or under the authority and
general direction of the manager; the manager must make the decision to enter into
the transaction; and the transaction must not be part of an agreement, arrangement
or understanding designed to benefit the party in interest. This requirement means
that a QPAM cannot serve merely to rubber-stamp a decision that has been made by
others. However, the language that permits the transaction to be negotiated “under the
authority and general direction” of the manager gives non-QPAM fiduciaries some room
to involve themselves in the transaction, and accommodates agents and subadvisers.
5. The party in interest cannot be either the manager or a person or entity “related” to the
manager. An entity is “related” to the manager if, as of the last day of its most recent
calendar quarter:
– The manager owns 10% or more of the entity;
– A person controlling or controlled by the manager owns 20% or more of the entity;
– The entity owns 10% or more of the manager; or
– A person controlling or controlled by the entity owns 20% or more of the manager.
For purposes of these tests, interests held in a fiduciary capacity are not counted
when applying the 10% or 20% test. In addition to these bright-line rules, ownership
interests between 10% and 20% may also cause parties to be considered “related” if
one party exercises control over the management or policies of the other by reason of
its ownership interest.
6. The terms of the transaction must be at least as favorable to the fund as terms generally
available in arm’s length transactions between unrelated parties. This test is applied
both at the time the transaction is entered into and at the time of any subsequent
renewal or modification that requires consent of the manager.
7. Neither the manager, nor any “aliate,” nor any direct or indirect 5% owner of the
manager, may be a person convicted of or released from prison with respect to a list of
specified felonies or other major crimes within the 10 years preceding the transaction.
This means that the bad acts of even certain remotely related parties can disqualify
the QPAM from using the QPAM Exemption. The Department of Labor has granted a
number of individual exemptions (i.e., exemptions available only to the applicant and
specified others) permitting use of the QPAM Exemption in such situations, subject to
certain additional conditions. Recent individual exemptions contain extensive lists of
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additional conditions, and it is currently unclear whether the Department of Labor
will continue to grant such individual exemptions in all cases. A plan fiduciary should
confirm that all of the requirements are or will be met before transacting under the
QPAM Exemption with fiduciaries relying on one of these individual exemptions.
The QPAM Exemption does not provide an exemption from the self-dealing prohibitions
of Section 406(b) of ERISA. It also does not provide an exemption for securities lending
or the acquisition of interests in mortgage pools or mortgage financing arrangements.
These transactions must meet the requirements of separate class exemptions.
SAMPLE COMPLIANCE POLICY
QPAM Exemption
The Chief Compliance Officer will be responsible for determining on at least an annual basis that the Firm
is a QPAM and for identifying any clients or circumstances with respect to which the QPAM Exemption
is unavailable.
All Client Intake documents require ERISA clients to identify any parties who have (or whose affiliates
in the financial services industry have) the power to appoint or terminate the Firm as manager over the
ERISA client’s assets managed by the Firm, or to negotiate the terms of an investment management
agreement with the Firm with respect to such assets.
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CHAPTER 5
Alternatives for Non-QPAMs
It is sometimes not possible for a manager to qualify as a QPAM, or a manager that is a
QPAM may be unable to use the QPAM Exemption for certain accounts or transactions.
For example, new managers may have a period of time before they meet the assets under
management test, or may have ERISA clients that account for more than 20% of their
assets under management. Managers in this situation may still manage investments under
other exemptions.
Other Status-Based Exemptions
Apart from the QPAM Exemption, there are four additional status-based class exemptions,
each of which covers a broad range of transactions. They are:
– PTE 90-1 – insurance company separate accounts
– PTE 91-38 – bank collective investment funds
– PTE 95-60 – insurance company general accounts
– PTE 96-23 – in-house asset managers
These exemptions are not covered by this Handbook. Managers that do not qualify as
QPAMs, but may qualify for use of one of these alternative status-based exemptions, should
contact counsel for advice.
Service Provider Exemption
A manager, whether or not it is a QPAM, can rely on the so-called Service Provider Exemption
set forth in Section 408(b)(17) of ERISA and Code section 4975(d)(20) for a wide variety
of transactions with parties in interest. The Service Provider Exemption applies only to
transactions between a plan and a party in interest that is a service provider but not a fiduciary
that exercises any discretionary authority or control with respect to the investment of the plan
assets involved in the transaction or that renders investment advice (or an aliate of such
a fiduciary). The Service Provider Exemption applies to the following types of transactions:
(1) the sale, exchange or lease of property between a plan and a party in interest; (2)
lending or money or other extension of credit between a plan a party in interest; or (3) the
transfer to, or use by or for the benefit of, a party in interest, of any assets of a plan.
The Service Provider Exemption will apply only if the plan receives no less, and pays no
more, than “adequate consideration.” The definition of “adequate consideration” for a
security for which there is a generally recognized market depends on whether such security
is traded on a registered national securities exchange:
n
Securities Traded on a National Securities Exchange. “Adequate consideration” means
the price of the security prevailing on a national securities exchange that is registered
under § 6 of the Securities Exchange Act of 1934, taking into account factors such as
the size of the transaction and marketability of the security.
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n
Securities Not Traded on a National Securities Exchange. If the security is not traded
on a national securities exchange but is still traded on a generally recognized market,
“adequate consideration” means a price not less favorable to the plan than the oering
price for the security as established by the current bid and asked prices quoted by persons
independent of the issuer and of the party in interest, taking into account factors such as
the size of the transaction and marketability of the security.
n
Assets Other than Securities for Which There Is a Generally Recognized Market. In the
case of an asset other than a security for which there is a generally recognized market,
the fair market value of the asset is determined in good faith by a fiduciary or fiduciaries
in accordance with regulations prescribed by the Secretary. These regulations have not
been promulgated.
Broker-dealer and bank counterparties may have varying levels of comfort relying on this
exemption if another exemption is available because, in the absence of regulations, in
some cases there is uncertainty about what counts as “adequate consideration.” Market
practice is evolving in this regard, so it may be worthwhile to discuss the exemption with
counterparties even if they have expressed discomfort with using it in the past.
Special-Purpose Exemptions
See the Section of this Handbook on “Transactions” for descriptions of commonly used
special-purpose exemptions, most of which can be used whether or not the manager is
a QPAM.
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CHAPTER 6
Non-U.S. Assets
Generally, managers of plan assets subject to ERISA have an obligation under Section 404(b)
of ERISA not to maintain the “indicia of ownership” of plan assets outside the jurisdiction of
the district courts of the United States, subject to limited exceptions. The indicia of ownership
rules may require, for example, a deed for non-U.S. real property, or subscription agreements
and similar documentation for non-U.S. partnership interests, to be held in the manager’s
U.S. oces.
Regulations provide several exceptions to this requirement that permit the indicia of
ownership of non-U.S. securities and non-U.S. currencies to be held outside the United
States. The simplest exception applies where the manager is a registered investment adviser
that is organized in the United States and has its principal place of business in the United
States and that has more than $50 million in assets under management and $750,000 in
shareholder or partner equity. Another exception applies where indicia of ownership are
physically held by (or are in transit to) a branch of a U.S. bank or a U.S.-registered broker
or dealer with net worth in excess of $750,000. A third exception applies where indicia of
ownership are maintained by a U.S. bank in the custody of a non-U.S. bank and certain
conditions are satisfied, including that the U.S. bank is liable to the ERISA plan to the
same extent it would be if it retained the physical possession of the indicia of ownership
within the United States.
A manager that is not organized in the United States or does not have its principal place
of business in the United States will not be able to take advantage of the first exception
described above. In order to maintain the indicia of ownership of non-U.S. securities and
non-U.S. currencies outside the United States, such a manager would need to satisfy another
exception, such as the exception that permits indicia of ownership to be maintained by a
U.S. bank in the custody of a non-U.S. bank.
It is not clear how the exception that permits indicia of ownership to be maintained in the
custody of a non-U.S. bank works for certain commonly traded types of securities, because
the indicia of ownership rules have not kept pace with the way in which assets are held.
In particular, questions have been raised about what constitutes the indicia of ownership
for uncertificated securities and certain new forms in which securities are traded, such as
A Shares traded on the Hong Kong, Shanghai and Shenzhen Stock Connect. There is no
guidance addressing this question. Ideally, responsibility for satisfying these rules should
be allocated to the ERISA client itself, together with its custodian and the custodian’s
non-U.S. sub-custodial network, because they are in a better position than the non-U.S.
manager to satisfy an applicable exception.
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CHAPTER 7
Fidelity Bonds
Section 412 of ERISA requires that every fiduciary of an employee benefit plan and every
person who handles funds or other property of such a plan be covered by a fidelity bond.
Personnel with discretionary authority to invest plan assets are treated as handling funds of
the plan. Persons whose duties with respect to plan investments are essentially advisory are
not treated as handling funds of the plan. The requirement will apply with respect to every
client that is a retirement plan, a master trust, or a commingled fund if the plan, trust or
fund is subject to Title I of ERISA.
A plan must be bonded for at least 10% of the amount of funds handled, subject to a
maximum of $500,000. If the plan holds employer securities, then a maximum of $1,000,000
applies. An “employer security” is a security issued by an employer of employees covered
by the plan, or by an aliate of such employer. Note that a plan is not considered to be
holding employer securities for this purpose merely because the plan invests in a broadly
diversified common or pooled investment vehicle that holds employer securities but that is
independent of the employer and its aliates. Thus, a manager’s purchase of an employer
security for a broadly diversified plan asset fund in which an ERISA client holds an interest
should not cause the relevant plan to be treated as holding employer securities for bonding
purposes. However, if the manager purchases an employer security for an ERISA client’s
separate account, the relevant ERISA plan would be treated as holding employer securities
for bonding purposes.
With respect to situations where assets of more than one plan are held together, the rules
state: “Where the funds or other property of several plans are commingled (if permitted by
law) with each other or with other funds, [the bonding] arrangement shall allow recovery to
be attributed proportionately to the amount for which each plan is required to be protected.”
Thus, for example, in the case of a client that is a master trust, the manager should look
through the master trust to determine the coverage required for each plan investing (directly
or indirectly) through the master trust.
Examples
1. Manager manages a $20 million separate account for a client that is a trust holding assets
of one plan, with no employer securities. The bond required for this client is the lesser of
(i) 10% of $20 million (i.e., $2 million) and (ii) $500,000. Thus the bond required for
this client is $500,000.
2. Manager manages a $20 million separate account for a client that is a master trust holding
assets of two plans, Plan A (which makes up 20% of the trust) and Plan B (which makes
up 80% of the trust), neither of which holds employer securities. The bond required for
this client must cover separately the $4 million that is attributable to Plan A and the $16
million that is attributable to Plan B. The bond required for Plan A is the lesser of (i) 10%
of $4 million (i.e., $400,000) and (ii) $500,000, or $400,000; the bond required for Plan
B is the lesser of (i) 10% of $16 million (i.e., $1,600,000) and (ii) $500,000, or $500,000.
Thus, the bond required for this client is $400,000 plus $500,000, or $900,000.
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The same reasoning applies to fidelity bonds for commingled funds that are subject to
ERISA. That is, a manager should look through a commingled fund to determine the
coverage required for each plan investing (directly or indirectly) in the commingled fund.
Examples
1. Manager manages an $80 million commingled fund that has one ERISA investor, a
trust holding assets of one plan, with no employer securities. This ERISA investor holds
25% of the fund. The bond required for this commingled fund is the lesser of (i) 10%
of $20 million (i.e., $2 million) and (ii) $500,000. Thus, the bond required for this
commingled fund is $500,000.
2. Manager manages an $80 million commingled fund that has two ERISA investors,
Plan A (which holds a 5% interest) and Plan B (which holds a 20% interest), neither
of which holds employer securities. The bond required for this commingled fund must
cover separately the $4 million that is attributable to Plan A and the $16 million
that is attributable to Plan B. The bond required for Plan A is the lesser of (i) 10%
of $4 million (i.e., $400,000) and (ii) $500,000, or $400,000; the bond required for
Plan B is the lesser of (i) 10% of $16 million (i.e., $1,600,000) and (ii) $500,000,
or $500,000. Thus the bond required for this commingled fund is $400,000 plus
$500,000, or $900,000.
If commingled funds and/or master trusts invest in other commingled funds and/or
master trusts, the rules apply on a look-through basis in a manner analogous to the
foregoing examples.
Managers should double-check their fidelity bond documentation to make sure the bond
covers client assets, not just plans sponsored by the manager for its own employees.
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SAMPLE COMPLIANCE POLICY
Fidelity Bonds
Separate Accounts
If the client is a single ERISA plan, the firm must determine whether the plan holds employer securities.
Generally, the firm should obtain a bond equal to 10% of the plan assets managed by the firm subject
to a $1 million maximum for plans holding employer securities and a $500,000 maximum for plans not
holding employer securities.
n
For new clients, information on whether the plan holds employer securities should be provided as part
of the intake process.
n
For existing clients, the firm should review the most recently filed Form 5500 for the plan to determine
whether the plan held employer securities during the plan year for which the form was filed (unless the
firm is itself holding employer securities for the plan). If the Form 5500 review shows that the plan did
not hold employer securities, the firm should contact the client asking for confirmation, stating that
the firm will assume the plan does not hold employer securities unless the client provides different
information.
If the client is a master trust holding assets of more than one ERISA plan, the firm should contact the
client to determine (i) how many plans hold interests in the master trust, (ii) what percentages of the
master trust each plan holds, and (iii) whether the underlying plans hold employer securities.
n
For new clients, this information should be provided as part of the intake process.
n
For existing clients, the firm should contact the client to obtain this information, stating that the firm
will assume that only a single plan holds an interest in the master trust and that no employer securities
are held unless the client provides different information.
For each underlying plan, the firm should generally obtain a $1 million bond if the plan holds employer
securities; otherwise, the firm should obtain a $500,000 bond. However, the firm should determine
whether any underlying plan’s interest in the separate account is less than $5 million ($10 million if the
plan holds employer securities). If so, the firm may limit the bond for such a plan to 10% of the plan’s
interest in the separate account.
Commingled Funds
For commingled funds that are subject to ERISA, the firm should determine the dollar value of the portion
of the fund attributable to each ERISA client. The firm can then determine the proper amount of the
fidelity bond to be obtained with respect to each ERISA client by treating such ERISA client’s investment
in the fund as if it were a separate account and following the procedures outlined above. However, the
firm should not treat an ERISA client (or an underlying plan) as holding employer securities merely
because the fund in which the ERISA client invests holds employer securities.
Updates
All determinations made and client information obtained for compliance with this policy should be
updated on an annual basis.
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Documentation
CHAPTER 8
Client Intake and Subscriptions
Individual Clients
It is standard practice to require new clients to complete forms designed to determine
their ERISA status and document any particular requirements that may apply to their
account, including information necessary to avoid prohibited transactions and/or ensure
the availability of needed exemptions.
Fund Investors
It is also standard practice to require all investors in a fund to complete a subscription
agreement that includes a questionnaire designed to determine the investor’s ERISA status.
In addition, each ERISA investor will generally be required to represent that (i) it is aware
of and has taken into consideration its fiduciary duties, including the diversification
requirements of Section 404(a)(1)(C) of ERISA; (ii) it has concluded that its proposed
investment in the fund is a prudent one; and (iii) the terms of the investment (including the
incentive fee and any restrictions on withdrawal) are in accordance with all requirements
applicable to the investor under its governing instruments and ERISA. ERISA investors
will generally also be required to acknowledge and agree that, for so long as the fund
is not deemed to hold plan assets, the general partner or managing member will not be
a “fiduciary” and that the investor is not relying on the general partner or managing
member to provide any kind of investment advice with respect to the investor’s purchase
of fund interests.
Systems Coding and Review
Despite a lack of guidance from the Department of Labor on requirements for compliance
and trading systems coding, proper compliance system and trading system coding is one
of the most important steps in avoiding ERISA compliance problems, including prohibited
transactions. Whenever a new ERISA account is established, the manager should ensure
that the account is coded as subject to ERISA, and that appropriate restrictions, such as
blocks on cross-trading, limitations on employer securities, and restrictions on trading
with parties that have “hire/fire” authority over the account (including their aliates) have
been properly entered into the system. It is also advisable for the manager to verify that all
of the restrictions are working properly on a periodic basis, or any time that the trading or
compliance systems are updated or changed.
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SAMPLE COMPLIANCE POLICY
Client Information
All separate account clients have completed intake forms indicating whether they are benefit plan
investors. Each Client Intake form should be reviewed by external counsel to confirm ERISA status and
identify any special issues.
All investors in the funds have completed subscription agreements indicating whether they are benefit plan
investors and, if so, the extent to which their invested assets are plan assets. The subscription agreements
further require the investor to notify the Firm of any changes. Each new subscription agreement should be
reviewed by external counsel to ascertain whether the responses to the ERISA section of the subscription
agreement appear on their face to be appropriate.
Each ERISA Client will be coded as subject to ERISA and/or Section 4975 of the code in the Firm’s trade
management and compliance systems, and all appropriate restrictions related to the account will be
coded and subject to review by a supervisor. All ERISA-related coding will be checked on a periodic basis.
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CHAPTER 9
Investment Management Agreements
Investment management agreements (IMAs) with ERISA clients generally will contain
certain provisions to accommodate the client’s ERISA-related needs and to avoid imposing
unnecessary burdens on the manager. A summary of relevant provisions is provided below.
The appointing fiduciary should expressly appoint the manager as an investment manager,
as defined in Section 3(38) of ERISA. The appointing fiduciary should represent that it is
a “named fiduciary” under ERISA. The appointing fiduciary should also represent that
the appointment of the manager is consistent with the plan’s documents.
The manager should acknowledge that it is a “fiduciary” under ERISA with respect to the
plan assets that it is managing.
The investor will generally represent that all actions contemplated under the IMA are
consistent with the plan’s documents and that the investor will notify the manager if
any plan provision changes in a way that would make that representation untrue. The
manager may agree to act in accordance with the plan documents.
The manager may represent that it is qualified to act as a QPAM. The QPAM Exemption
does not require a manager to agree that it will act in accordance with the requirements of
the Exemption or that each transaction will be exempt by application of the Exemption,
but managers commonly do so agree.
The manager may undertake to vote proxies in accordance with its fiduciary duties under
ERISA, unless the IMA specifically identifies another party as responsible for voting the
proxies or reserves the right to the named fiduciary of the investing plan.
The manager generally should avoid having discretionary authority to value assets on which
a management fee or performance fee is based. The manager also generally should not have
the ability to increase its fees by allocating assets to a particular investment strategy.
The manager may agree to diversify the account in accordance with ERISA, but the
manager would normally not make any commitment with respect to the overall
investment strategy of the plan. Some managers seek to disclaim the duty of diversification,
particularly with very targeted investment strategies.
A U.S.-based manager may agree to comply with the “indicia of ownership” requirements
under ERISA. A non-U.S. manager generally should consult with counsel with regard to
these requirements and any related contractual undertakings.
With respect to any client-directed brokerage arrangement, the investor generally will
be required to represent that the direction of its account to a specified broker and the
brokerage commission rate (i) are in the best interest of the account; (ii) are for the
exclusive purpose of providing benefits to participants and beneficiaries of the plan; and
(iii) are not, and will not cause the account to be engaged in, a prohibited transaction.
The investor will generally also represent that it has determined, and will monitor the
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account to ensure, that the directed broker is capable of providing best execution for the
account’s brokerage transactions and that the commission rates that have been negotiated
are reasonable in relation to the value of the brokerage and other services received.
If referenced in the IMA, any “soft dollars” arrangement must comply with the safe harbor
standards under Section 28(e) of the Securities Exchange Act of 1934.
The manager generally will agree to be bonded as required under ERISA, unless the
investor agrees to cover this obligation.
The manager may not be indemnified out of plan assets for any breach of its fiduciary
duties. Therefore, the indemnification provisions of the IMA should permit indemnification
only to the extent permitted by applicable law, including ERISA.
The manager generally will not agree to avoid or monitor transactions in employer
securities unless the investor provides a list of such employer securities and/or guidelines
for handling such securities.
SAMPLE COMPLIANCE POLICY
Investment Management Agreements
The Firm maintains a standard form of investment management agreement for ERISA clients that has
been reviewed by outside counsel for compliance with ERISA. All client agreements can be accessed
through Client Intake. The Firm will have outside counsel comment on any alternative terms or conditions.
Any comments will be retained with the client files.
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CHAPTER 10
Prime Brokerage and Derivatives
Managers of plan asset funds often will enter into so-called prime brokerage arrangements
that cover a suite of services in addition to execution of trades. Other services may include
margin loans, foreign exchange transactions, and securities lending, and the prime broker
may in some cases act as counterparty in swap transactions.
Special considerations arise from the prime broker’s holding and use of assets pledged
as collateral in connection with certain transactions. Similar considerations arise in
connection with ISDA agreements governing swap transactions and GMRAs governing
repurchase transactions. Two recurrent questions that arise in connection with these
arrangements are whether the collateral held by the broker or counterparty remains
subject to ERISA in the hands of the broker or counterparty and what permits the broker
or counterparty to exercise certain agreed rights over assets in the account, such as oset
and closeout rights.
The Department of Labor has addressed these issues in limited contexts in a manner that
has given practitioners comfort that assets pledged as collateral do not retain their plan
asset character in the hands of the counterparty. Specifically, the Department has stated
that when assets are held by a futures commission merchant (FCM) to fund a plan’s
margin account, the assets in the account are not plan assets; rather, when a plan engages
in a futures transaction, “its assets are the rights embodied in the futures contract as
evidenced by a written confirmation and outlined in its agreement with its FCM. . . .”
Similarly, the Department has stated that when assets being used for cleared swaps are
held in a margin account, the assets in the account are not plan assets; rather, when a
plan engages in cleared swaps, “its assets are the rights embodied in the swap contract as
evidenced by the written agreement” between the plan and its clearing member.
The Department of Labor has also opined that the exercise of closeout rights over
amounts in an ERISA account can be treated as exempt under the QPAM Exemption, if
the rights have been spelled out in detail in the agreement. Specifically, the Department
has stated in the cleared swaps context that the QPAM Exemption provides relief for such
transactions as “subsidiary transactions” if the agreement governing the swap clearing
services contains enough specifics of such subsidiary transactions that the potential
outcomes are reasonably foreseeable by the QPAM when negotiating and entering into
the agreement.
In view of the foregoing considerations, managers entering into prime brokerage and
derivatives agreements on behalf of ERISA accounts will typically need to consider the
following:
1. The agreement will usually require that the manager represent that it is a QPAM and
represent that the QPAM Exemption is available for transactions under the agreement.
Sometimes this representation is made on the basis of assumed conditions agreed by
the parties.
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2.
In the case of a prime brokerage agreement, the prime broker is a service provider to
the ERISA customer, so its compensation needs to be reasonable and it needs to give
the customer a full fee disclosure to satisfy the exemption under ERISA for reasonable
compensation paid for necessary services. (See Chapter 11.)
3.
Generally, a prime broker will ask for assurances that the ERISA customer does not
and will not treat any assets pledged as collateral as “plan assets.” The DOL guidance
on analogous situations described above is generally sucient for managers to be
comfortable operating in this way, but it is more appropriate to word this provision as
an agreement or acknowledgment between the parties rather than as a representation
regarding the legal status of the assets. These assurances are also often made by the
prime broker to the ERISA customer.
4.
A prime broker may also ask for assurances that certain uses of the ERISA customer’s
assets are exempt from the prohibited transaction restrictions. Again, the DOL
guidance on analogous situations described above is often sucient for managers to be
comfortable with their ability to use the QPAM Exemption to cover such transactions,
as subsidiary transactions.
It is common for ISDAs to contain more or less elaborate ERISA-related termination
events, disclosure obligations, and representations. It is generally advisable for a manager
to have ERISA counsel review these sections, perhaps after discussing with counsel what
an appropriate “standard” set of ERISA provisions should include and exclude. Attention
should also be paid to the form of derivative documentation being used and whether all
requirements of any applicable exemptions have been met.
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Client Relations
CHAPTER 11
Reporting and Disclosure
Managers of ERISA accounts have certain disclosure obligations and certain responsibilities
to assist the underlying ERISA plans with their annual reporting obligations. For example,
ERISA plans must report annually on the assets held in plan asset funds in which they
invest; accordingly, the manager of such a fund should be ready to disclose the fund’s
holdings.
The most significant disclosure and reporting obligations relate to compensation received
by service providers, including asset managers. The details are set out below.
Compensation Reporting
Most ERISA plans must file a public report (Form 5500, Schedule C) showing all
compensation received by service providers to the plan, including managers of funds
in which the plan’s assets are invested. Service providers to ERISA plans must provide
information needed to comply with the plan’s reporting obligations. This requirement
applies to all investment funds (other than funds that are treated as operating companies,
such as VCOCs and REOCs) in which an ERISA plan holds an interest, whether or not
assets of the fund are deemed to be “plan assets”—including mutual funds as well as
non-registered funds.
ERISA plans generally must report the following compensation-related information:
–
The identity of any person receiving $5,000 or more for services;
–
Any relationship between such person and the plan sponsor or other parties in
interest to the plan;
–
One or more codes describing the services; and
–
The amount of any compensation paid directly.
If a service provider received indirect compensation—that is, amounts paid by someone
other than the plan in connection with services provided to the plan—the plan must
report the amount of indirect compensation paid, or a formula for calculating it, unless
a special exception described below applies. Additional information must be reported
for certain service providers that may be exposed to conflicts of interest, including
investment managers. For this class of service providers, each source paying $1,000 or
more in indirect compensation must be disclosed, except as described below.
Under a special exception for so-called eligible indirect compensation, no amount needs
to be reported for a recipient of indirect compensation (such as a fund manager) if (i)
the compensation consists of fees or expense reimbursements reflected in the value of the
investment, finder’s fees, soft dollar revenue, float revenue, brokerage commissions or
other transaction-based fees for transactions or services involving the plan, and (ii) the
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plan receives written disclosure of:
– The existence of the indirect compensation;
–
The services provided for the compensation;
– The amount or an estimate of the compensation, or a formula used to determine
the amount; and
– The identity of the parties paying and receiving the compensation.
Managers who want to avoid extensive and detailed public disclosure of fee-related
information will generally try to make sure that ERISA plans receive a written disclosure
satisfying these requirements. The disclosure can be set forth in existing documents
(e.g., an oering memorandum) as long as ERISA investors are told which parts of the
documents are intended to satisfy the requirements. If an investment manager receives
only eligible indirect compensation in connection with plan investments, all the plan
has to report is the identity and EIN or address of the person providing the plan
administrator with the written disclosure. The person providing the disclosure need not
be the investment manager.
The consequences of noncompliance with the obligation to provide information necessary
to complete Schedule C can be severe. A service relationship with an ERISA plan will be
a per se prohibited transaction unless the service provider supplies this information in a
timely manner.
Compensation Disclosure
Certain service providers are obligated to make an up-front disclosure relating to their
compensation. The service provider fee disclosure rules apply to a “covered service
provider,” which means a service provider that enters into a contract with a plan or a
plan-asset fund to provide fiduciary, registered investment advisory, recordkeeping or
certain other services (e.g., accounting, custodial and consulting services), and reasonably
expects to receive at least $1,000 in compensation for the services provided.
All covered service providers must disclose to the contracting plan fiduciary in writing:
– The services to be provided;
– Whether the covered service provider will act as a fiduciary or investment adviser
registered under the Investment Advisers Act of 1940 or state law;
– All compensation reasonably expected to be received, including:
– Direct compensation;
– Indirect compensation, with a description of the arrangement between the
payer and the covered service provider or its aliates or subcontractors;
– Compensation paid among the covered service provider and its aliates or
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subcontractors, if charged on a transaction basis (e.g., commissions, soft dollars,
finder’s fees or other similar incentive compensation paid based on business
placed or retained) or charged directly against the investment and reflected in
the value of the investment (e.g., Rule 12b-1 fees), together with a description
of the services for which such compensation is paid, and the identities of the
payer and recipient;
– Compensation that the covered service provider would receive in connection with
the termination of the contract and how prepaid amounts would be calculated
and refunded upon termination.
If a fund is used as a designated investment alternative under a participant-directed
individual account plan, the plan administrator will have an obligation to make annual
disclosures to participants relating to fees charged by the fund. For this reason, the
following must also be disclosed by the covered service provider, if applicable, on a
regular basis:
– Total annual operating expenses for an investment where the return is not fixed,
and any ongoing expenses (e.g., wrap fees, mortality and expense fees);
– Total annual operating expenses expressed as a percentage and calculated in
accordance with the participant-level fee disclosure rules that apply to plan
administrators; and
– Any other information about the designated investment alternative that is required
for the plan fiduciary to comply with the participant-level fee disclosure rules
and that is within the control of, or reasonably available to, the covered service
provider.
If a covered service provider acts as a fiduciary with respect to the plan or investment
entity that holds plan assets, the following disclosures must be made with respect to
each investment product that holds plan assets and in which the plan has a direct equity
investment:
– Compensation charged against the investment (e.g., commissions, sales loads,
sales charges, deferred sales charges, redemption fees, surrender charges, exchange
fees, account fees and purchase fees) that is not included in the annual operating
expenses of the investment; and
– Annual operating expenses for an investment where the return is not fixed, and
any ongoing expenses (e.g., wrap fees, mortality and expense fees).
Generally, initial disclosures must be provided reasonably in advance of the date the
contract or arrangement is entered into, renewed or extended. Information changes must
be disclosed as soon as practicable, but not later than 60 days from the date the service
provider knows of the change, except that changes to investment-related information
are to be reported at least annually. Certain plans may also request to receive updated
disclosure every year. Compensation information requested by a plan fiduciary for
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purposes of complying with reporting and disclosure requirements under ERISA must be
provided reasonably in advance of the date on which the plan fiduciary or administrator
states that it needs the information. There are special timing rules for disclosure with
respect to investments that are later determined to hold plan assets or investments that
later become designated investment alternatives.
There is no required format for written disclosures, and disclosures may be made
through one or more documents. However, the regulations contain a “guide” that service
providers are encouraged by the Department to use when making initial disclosures to
plan fiduciaries.
Covered service providers are protected if errors or omissions are made in good faith and
the service provider acted with reasonable diligence, as long as the error or omission is
corrected within 30 days after discovery. Covered service providers must comply with a
plan fiduciary’s request to correct an error or omission. Failure to comply will in some
cases require the fiduciary to terminate the service contract.
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CHAPTER 12
Gifts and Entertainment
ERISA prohibits a plan fiduciary from receiving consideration for his or her personal
account from any party dealing with the plan in connection with a transaction involving
assets of the plan. However, the Department of Labor’s Enforcement Manual treats the
receipt of gifts, gratuities, meals, entertainment or other consideration with an aggregate
annual value of less than $250 as insubstantial and not as a violation of ERISA’s
prohibited transaction rules. The implication is that exceeding the $250 threshold could
result in a prohibited transaction that would be subject to enforcement. Some financial
firms have ERISA-specific gifts and entertainment policies based on the Department of
Labor’s enforcement approach, and such policies generally are advisable and appropriate
where a firm regularly deals with ERISA investors.
The Enforcement Manual sets out an exception for reimbursement of educational
expenses associated with a plan representative’s attendance at a conference, as long as a
plan fiduciary has reasonably determined in writing, in advance and without regard to
whether the expenses would be reimbursed, that (i) the plan’s payment of the expenses
was prudent and consistent with a written plan policy or provision designed to prevent
abuse, (ii) the conference had a reasonable relationship to the duties of the attending plan
representative, and (iii) the expenses were reasonable in light of the benefits aorded and
unlikely to compromise the plan representative’s ability to carry out his or her ERISA duties.
Some financial services providers oer reimbursement to ERISA plan representatives for
conference expenses using a form intended to ensure that a plan fiduciary has made the
required determinations. Based on the Enforcement Manual, many institutions require
fiduciaries to obtain prior clearance before accepting any gifts or entertainment from
clients or vendors or giving any gifts to ERISA fiduciaries (i.e., the investment committee
of a plan client). Where prior clearance is not possible, it is common to require prompt
reporting to the compliance department of gifts and entertainment.
ERISA imposes Form 5500 reporting requirements on ERISA plan administrators
with respect to gifts, meals and similar items exceeding a certain amount in value,
and some firms have more restrictive ERISA-specific gifts and entertainment policies
intended to help plans avoid having to report such items. In particular, all non-monetary
compensation must be reported unless it is of “insubstantial value.” The “insubstantial
value” exception applies when (a) the value of the item is tax deductible for federal
income tax purposes for the provider and would not be taxable income to the recipient,
(b) each gift item is valued at less than $50 and (c) the aggregate annual value of all items
received from a single source is less than $100. Gifts of less than $10 in value do not
count toward the $100 threshold; however, if the $100 threshold is exceeded, the value
of all gifts must be reported. Items received by one person from multiple employees of the
same entity must be treated as a single source, and their value must be consolidated for
purposes of calculating the $100 threshold. By contrast, the value of items received from
one person by multiple employees of the same entity should be separately determined
for each employee. The requirement that gifts or other items be tax deductible by the
provider and not taxable income to the recipient imposes additional restrictions on what
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SAMPLE COMPLIANCE POLICY A
Gifts and Entertainment
The Firm and its employees may not provide any person who is a fiduciary of an ERISA plan gifts, enter-
tainment or other consideration with an aggregate annual value of $250 or more. Cash gifts and gifts of
$50 or more in value are not allowed.
is considered to be of insubstantial value. Business meals are deductible if the provider is
present and the meal is not “lavish or extravagant under the circumstances.” However,
business gifts are only tax deductible up to an aggregate annual limit of $25 per recipient.
Examples
1. An investment manager receives two gifts and two meals in connection with services
provided to a plan, with values of $6 and $8 (gifts) and $40 and $49 (meals). The
$6 and $8 gifts do not count towards the $100 threshold. Since only the $40 and
$49 meals are used in calculating the amount to be disclosed, the $100 limit is not
exceeded ($89 is less than $100), and none of the items must be reported.
2. An investment manager receives three gifts and two meals valued at $6, $8 and $11
(gifts) and $40 and $49 (meals). The $6 and $8 gifts do not count towards the $100
threshold. However, the aggregate value of the three items valued at more than $10 –
the $11, $40 and $49 items – reaches the $100 threshold, so the value of all five items
($114) must be reported.
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SAMPLE COMPLIANCE POLICY B
Gifts and Entertainment
All employees that are ERISA fiduciaries are required to notify the Chief Compliance Officer in advance
of giving or accepting any gifts or entertainment in connection with their services for an ERISA account
and to seek preapproval of such gifts or entertainment. If advance notice is not practicable, then an
employee who is an ERISA fiduciary must notify the Chief Compliance Officer as soon as reasonably
practicable following the giving or receipt of such gifts or entertainment. For the avoidance of doubt, all
gifts and entertainment given or received by an ERISA Fiduciary are subject to this paragraph, including
de minimis items.
Employees are prohibited from giving or accepting gifts, entertainment or similar items in connection
with any services provided by the Firm to a client that is a pension plan subject to Form 5500 Schedule
C reporting obligations unless the following three conditions are all met: (i) the item is tax deductible for
federal income tax purposes for the provider and would not be taxable income to the recipient; (ii) the
item is valued at less than $50; and (iii) items received from any one person during a calendar year are
valued at less than $100. Note that a gift otherwise permissible under these limits may be impermis-
sible as a result of federal income tax rules on tax deductibility of business gifts and meals. For example,
business meals are deductible as long as the provider is present and the meal is not lavish or extravagant
under the circumstances, while business gifts are only tax deductible up to an aggregate annual limit of
$25 per recipient.
Gifts and entertainment received from multiple employees of a single entity will be treated as coming from
a single source when calculating whether the $100 limit applies. However, in applying the limit to an oc-
casional gift received by multiple employees from a single person, the amount received by each employee
may be separately determined in applying the $100 limit.
Employees may give or accept occasional gifts or entertainment of less than $10 in value without the gift
counting toward the $100 limit. Employees may also give or accept promotional gifts of little intrinsic
value that display a company logo (for example, pens with the company name).
If a vendor or service provider provides services to the Firm relating to its pension plan clients and its
non-pension plan clients, a pro rata share of the value of any item received by the Firm should be counted
towards the $50 and $100 limits. For example, it would be permissible for the Firm to accept a holiday
gift basket from a broker worth $75 if 90% of the business the broker has with the Firm is non-pension
plan business.
Compliance with the limits set forth in this policy is designed to prevent pension plan clients of the Firm
from having to comply with certain Form 5500 Schedule C reporting obligations. Employees should be
aware that even if these limits are followed, the provision or acceptance of gifts or entertainment of any
value by the Firm in connection with the services it provides to pension plan clients may nonetheless
violate ERISA and may give rise to civil liabilities and criminal penalties. Consultation with your supervisor
or the Compliance Department before providing or accepting any gift or entertainment in connection with
services provided to pension plan clients is advised.
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Transactions
CHAPTER 13
Trading Basics
Many ordinary-course securities transactions that may involve parties in interest are not
regarded by the Department of Labor as prohibited transactions. Certain transactions
that would be prohibited absent an exemption can be covered by readily available
exemptions even if the manager does not have the benefit of a status-based exemption,
such as the QPAM Exemption.
Trades on Exchanges
Transactions executed on a national exchange are generally “blind” transactions, where
neither party knows the identity of the other party. Blind transactions are not regarded
as prohibited transactions and therefore do not require an exemption, even if it should
turn out that the other party to the transaction is a party in interest.
Alternative Trading Systems
Transactions executed through certain alternative trading systems are designed to be
blind transactions. The Department of Labor has stated that blind transactions executed
through alternative trading systems are not prohibited transactions. However, the
Department cautioned that fiduciaries using an alternative trading system for a blind
transaction must be careful to make sure that the transaction is truly blind.
There is a statutory exemption covering transactions placed through an electronic
communication network or similar system, even if the transactions are not truly blind.
Transactions may be placed for an ERISA plan through an electronic communication
network or similar system if:
–
The network or system is subject to federal regulation and oversight;
– The identities of the parties are not taken into account in the execution of trades;
–
Rules are in place to match purchases and sales at the best price available;
–
Price and compensation are at least as favorable to the ERISA plan as in an arm’s
length transaction; and
– A plan fiduciary is notified at least 30 days in advance of the first use of the network
or system.
Under the exemption, electronic networks or similar systems may be used even with
a party in interest to the ERISA plan that has an ownership interest in the network or
system, as long as the network or system has been authorized for the plan’s use by the
plan sponsor or another independent fiduciary.
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Principal Transactions
Even if a manager does not have the benefit of a status-based exemption such as the
QPAM Exemption, PTE 75-1, Part II permits principal trades of securities to be executed
with a party in interest. The conditions for using this exemption are as follows:
–
The other party to the purchase or sale must be a registered broker that customarily
purchases and sells securities for its own account in the ordinary course of business;
and
–
The other party to the purchase or sale must not have or exercise any discretionary
authority or control (except as a directed trustee) or render investment advice
with respect to the investment of the plan assets involved.
The exemption is also available for purchases or sales of U.S. government or agency
securities with either (a) a reporting dealer who makes primary markets in U.S.
government or agency securities and reports daily to the Federal Reserve, or (b) a bank
supervised by the United States or a state. The dealer or bank must customarily purchase
and sell such securities for its own account in the ordinary course of business.
Margin and Short Sales
Trading on margin and short sales involve an extension of credit by a broker that is a
party in interest by reason of providing services. That extension of credit is a prohibited
transaction in need of an exemption. Typically, coverage would be available under
a general-purpose exemption, e.g., the QPAM Exemption or the Service Provider
Exemption. However, if a general-purpose exemption is not available, there is a special-
purpose exemption in PTCE 75-1, Part V, for extensions of credit in connection with
securities transactions. In order for this exemption to apply, the following conditions
must be satisfied:
– The extension of credit must be permissible under the securities laws;
–
If the party in interest is a fiduciary, the fiduciary must receive no interest or other
consideration; and
–
The plan must maintain records for six years that are sucient to demonstrate
compliance with the terms of the exemption.
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CHAPTER 14
Affiliated Brokers
A fiduciary’s selection of itself or an aliate as a broker to place trades would generally
be a prohibited transaction, because the fiduciary would be using its authority to cause
an additional fee to be paid to itself or the aliated broker-dealer. However, a commonly
used class exemption, PTE 86-128, provides a conditional exemption covering use of an
aliated broker, as long as the trades are not excessive in either amount or frequency.
The conditions of the exemption, as applied to separately managed accounts, are as follows:
–
A plan fiduciary must provide advance written authorization, which must be
terminable at will without penalty;
– The authorizing fiduciary must be provided, within three months before the
authorization, with any reasonably available information necessary to determine
whether to give the authorization, including a copy of PTE 86-128, a form for
termination of the authorization and a description of the broker’s placement
practices;
– The trading fiduciary must furnish the authorizing fiduciary a confirmation slip
within 10 days of each trade; or, alternatively, the trading fiduciary may provide,
within 45 days of quarter-end, a quarterly report describing each trade, the total
of all charges paid by the plan, and the amount of these charges retained by the
fiduciary or aliate and the amount paid to other persons for execution or other
services;
– The trading fiduciary must provide, within 45 days of each year-end, a report
including the same information a quarterly report would contain, plus a description
of any material changes in brokerage practices during the year and the annualized
portfolio turnover ratio for the plan.
The exemption is not available if the fiduciary is a plan administrator or an employer
whose employees are covered by the plan, unless the fiduciary returns or credits to the
plan all profits earned in connection with the trades. In such a case, however, arguably
the exemption is not needed because the fiduciary is not using its authority to cause an
additional fee to be paid to itself or an aliate.
The exemption is available for plan asset funds, with some modifications to the conditions.
Specifically, fiduciaries of plans investing in the fund must give advance authorization,
and if they do not agree to the arrangement, they must be permitted to terminate their
investment in the fund without penalty before an aliated broker is used.
The exemption is also available for IRAs and other plans that do not cover employees,
in which case the authorization and reporting conditions listed above do not need to
be satisfied.
Special conditions apply if the plan in question covers employees of the fiduciary
placing trades.
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CHAPTER 15
Affiliated Underwriters
A manager of ERISA plan assets may seek to purchase publicly oered securities during
the existence of an underwriting or selling syndicate that includes the manager or an
aliate of the manager. The Department of Labor has long considered it a prohibited
transaction for a manager to purchase a security in this circumstance either from the
manager itself or from its aliate. Even a purchase from another member of the selling
syndicate might be a prohibited transaction, the Department has stated, because “it is
generally in the interests of the members of an underwriting syndicate that all shares
being oered by the syndicate are sold.”
However, a class exemption, PTE 75-1, Part III, is available for purchases from a member
of the selling syndicate other than the manager or its aliate. The exemption has a variety
of technical conditions not addressed here, but a key condition is that the exemption is
not available if the manager or its aliate is a “manager” of the selling syndicate. For
this purpose, a “manager” is any member of the syndicate who is authorized to act on
behalf of the members of the syndicate or who receives compensation from the members
of the syndicate for services as a manager of the syndicate. In some cases, members of
a syndicate may be called “managers” but not possess this authority. In these cases,
the availability of the exemption may be unclear. The Department has issued multiple
individual exemptions that cover a broader range of aliated underwriter transactions
than PTE 75-1.
Some take the view that if the aliated underwriter does not receive compensation from
the members of the syndicate for its services in selling securities, there should be no
prohibited transaction. The implication of this view is that if the aliated underwriter
renounces a portion of its selling concession corresponding to the portion of the securities
purchased by the manager for its ERISA accounts, the conditions of the class exemption
should not have to be satisfied. It is worth noting that renouncing selling concessions in
this manner is a condition of certain individual exemptions allowing purchases of this
kind on generally more relaxed terms than those of the class exemption. A manager that
wants broad flexibility to purchase securities during the existence of an underwriting
syndicate that includes an aliate of the manager should consider applying for an
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individual exemption of this kind.
CHAPTER 16
Affiliated Funds
A fiduciary with respect to ERISA plan assets that considers it appropriate to invest
those assets in a fund managed by the fiduciary or an aliate faces the prospect of a
prohibited transaction by reason of using its fiduciary authority to cause the plan to pay
it or its aliate an additional fee for services. Fortunately, one of the earliest prohibited
transaction exemptions, PTE 77-4, provides a road map to carry out such investments
safely, at least for investments in mutual funds. Under the exemption:
–
No sales commission can be charged.
– No redemption fees can be charged, except fully disclosed redemption fees paid
only to the fund.
– The plan cannot be charged double advisory or management fees; either the plan
must not pay a plan-level fee with respect to the assets invested in the mutual fund,
or the plan must receive a credit against its plan-level fee for its pro rata share of
advisory fees paid by the fund.
– A plan fiduciary independent of the manager must be given a prospectus and
detailed written disclosure of all fees, stating the reasons why the manager considers
the investment appropriate for the plan and whether there are any limitations on
the manager with respect to which plan assets may be invested in the mutual fund.
– The independent plan fiduciary must consent to the investment and to any changes
in fees.
This exemption is not available for aliated investments other than investments in
aliated mutual funds. Investments in aliated bank collective trusts can be covered under
a statutory exemption at Section 408(b)(8), which actually oers broader relief then PTE
77-4. However, investments in other types of aliated funds have no express exemption.
With respect to investments in other types of aliated funds, some practitioners take the
view that satisfaction of the conditions of PTE 77-4 should be sucient to ensure that
there is no prohibited transaction in need of exemption. The argument is that if these
conditions are satisfied, the fiduciary is not using its authority to cause the plan to pay an
additional fee to itself or an aliate.
The DOL has called attention to the fact that an investment in an aliated fund could
give rise to an independent prohibited transaction, without exemption, if the fiduciary
is using the investment to serve its own purposes or those of an aliate. In particular,
the DOL has expressed concerns about the use of ERISA plan assets to seed a new fund.
Because such separate issues can easily arise in connection with investments of this kind,
it is advisable to consult ERISA counsel before entering into a new arrangement, even one
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that satisfies the terms of PTE 77-4.
CHAPTER 17
Cross-Trades and Other Conflicts of Interest
Because of the conflict of interest restrictions in Section 406(b)(2) of ERISA, the
Department of Labor takes the view that a manager can enter into cross-trades, i.e.,
trades between an ERISA account and another account managed by the same manager,
only if an explicit exemption is available. Cross-trades typically must be avoided,
because of the diculty of using available exemptions. Arranging a cross-trade through a
broker, or through two cooperating brokers, is likewise not permitted. As a result, many
managers prohibit entering into buy and sell transactions involving the same security on
the same day through the same broker where an ERISA account is involved. For certain
low-trading volume securities, certain managers extend this prohibition on same security
trades to a longer period than a single day. In addition, it is important for managers to
avoid any prearrangement of buy and sell orders for the same security when an ERISA
account is involved.
However, two exemptions are available, each subject to several conditions. The
exemptions each require managers to provide fiduciaries of participating ERISA plans
with written policies governing the manager’s cross-trading program. In addition, under
a long-standing “blind trade”doctrine, an ERISA account may generally enter into a
securities transaction without concern over potential cross-trades where the account is
not aware of the identity of the counterparty to the transaction.
Cross-trades may be covered by a statutory exemption at Section 408(b)(19) of ERISA.
The exemption covers only securities for which market quotations are readily available.
Generally, the exemption requires the manager (i) to develop policies and procedures to
govern cross-trades, (ii) to obtain the consent of clients to participate in the cross-trading
program, after providing full disclosure, (iii) to carry out any cross-trades in accordance
with its policies and procedures, and (iv) to provide quarterly reports and carry out an
annual compliance review.
Certain “passive” cross-trades may be carried out under a special-purpose class exemption
even if the general statutory exemption for cross-trading is not available. PTE 2002-12
provides an exemption for cross-trades involving index and model-driven funds or portfolio
restructurings for large accounts. However, PTE 2002-12 covers only trades involving
equity securities that are widely held and actively traded and for which market quotations
are readily available from independent sources and fixed-income securities for which
market quotations are readily available from independent sources. Generally, PTE 2002-
12 requires the manager (i) to adopt and follow written procedures for its cross-trading
program, (ii) to provide advance written notice to investors in funds participating in the
cross-trading program, (iii) to adhere to certain pricing and timing requirements, and (iv)
to satisfy certain recordkeeping and annual notice requirements.
Please note that the prohibition on cross-trading applies only to plans or accounts subject
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to ERISA, and not to IRAs or similar plans or accounts that are not subject to ERISA.
Similar conflicts of interest may arise where a manager is acting on behalf of multiple
accounts (one or more of which is an ERISA account) that hold dierent securities issued
by the same company. In these cases, care must be given when exercising any security
holder’s rights with respect to one account’s holdings where there may be adversity of
interest with another account. A common example would be where an ERISA account
holds senior debt and another account holds junior debt of the same issuer and the
ERISA account must determine whether to exercise its rights to preserve the value of its
own securities, thereby lowering the value of the junior debt held by the other account.
In these cases, a manager may take steps to insulate the decision-making process on
behalf of dierent accounts, including potentially hiring an independent fiduciary. These
types of conflict situations can be challenging and costly to address when they arise, so
managers may want to include formulaic rules for addressing certain conflicts under their
formative documents. This approach may also be beneficial for managers of funds of
funds or secondaries funds who may face these types of conflicts as the funds they hold
interests in wind down.
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CHAPTER 18
Foreign Exchange
Foreign exchange transactions are principal trades with a third party, typically a bank
or a broker-dealer, that may well be a party in interest to the ERISA investor engaging
in the trade. Accordingly, an exemption is typically required for such transactions. The
QPAM Exemption is the exemption most often used, and it is increasingly expected by
counterparties to be the exemption relied upon. However, the Service Provider Exemption
may also be available to cover foreign exchange transactions.
There is also a special-purpose statutory exemption at ERISA Section 408(b)(18)
covering foreign exchange trades. However, the statutory exemption covers only trades
in connection with the purchase, holding or sale of securities or other investment assets,
and therefore does not cover speculative trades or other trades unrelated to investment
holdings. The conditions for the exemption are as follows:
– At the time the transaction is entered into, the terms must be not less favorable to
the plan than the terms generally available in comparable arm’s length transactions
between unrelated parties, or the terms aorded by the bank or broker dealer.
– The exchange rate must not deviate by more than 3% from the interbank bid and
asked rates for transactions of comparable size and maturity as displayed by an
independent reporting service.
– The counterparty must not have investment discretion or provide investment advice
with respect to the transaction.
Additional special-purpose exemptions are available for standing instruction trades and
for trades not relating to existing investment holdings. However, these exemptions are
rarely used.
A question that arises with some regularity is whether an asset manager can aggregate
and net foreign exchange trades using an internal system or third-party service, before
submitting the net trades to its foreign exchange counterparty. As a general matter, such
netting procedures, while attractive economically and generally advantageous for clients,
raise concerns about impermissible cross-trading. However, the ERISA analysis of such
netting procedures is highly fact-dependent and should be discussed with ERISA counsel.
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CHAPTER 19
Asset-Backed and Mortgage-Backed Securities
Dealings in ABS and MBS for ERISA accounts may involve some complexity, depending
on the nature of the securities. Generally, oering materials for the securities should be
reviewed to determine the nature of the securities, whether ERISA investors are permitted
to invest in a specific security, and if so, what exemptions may be needed to acquire and
hold the securities.
The simplest case is presented by securities that are treated as debt instruments with no
substantial equity features. For such securities, the QPAM Exemption (or another status-
based exemption) or the Service Provider Exemption will likely be needed to cover the
extension of credit to the issuer (which may be a party in interest) and the purchase of the
security from the underwriter (which, likewise, may be a party in interest).
Another straightforward case involves securities that are treated as equity (typically called
“certificates”) for purposes of ERISA but that either are “publicly oered securities” or
are issued by an issuer the assets of which are not treated as plan assets because less
than 25% of each class of equity interest is held by benefit plan investors. The latter case
may be somewhat rare, as it is not typical for the issuer of such securities to monitor
benefit plan investor participation. In these cases, again, the QPAM Exemption or the
Service Provider Exemption will be needed to cover the purchase of the security from the
underwriter, which may be a party in interest.
A third case not raising significant concerns involves certificates issued by Fannie Mae,
Freddie Mac or Ginnie Mae. The assets underlying these securities are specifically exempted
from being treated as plan assets.
Complexities arise in the case of securities that are treated as equity and that are issued by
an issuer the assets of which may be treated as plan assets. One consideration is whether
the underlying asset pools will be operated in accordance with the fiduciary requirements
of ERISA. Typically, little or no discretion is exercised at the level of pool operations, so
this is often considered not to be a serious concern. A more important consideration is
whether the operation of the asset pool could give rise to a prohibited transaction, given
that the parties involved are often related to each other and may be parties in interest
to investing ERISA plans. However, many ABS and MBS are issued pursuant to so-called
Underwriters Exemptions, which are administrative exemptions with nearly identical
terms under which many of the major ABS and MBS sponsors enjoy protection against
common prohibited transactions relating to the operation of the underlying asset pool.
A manager that is purchasing ABS and MBS equity for an ERISA account should in most
cases confirm that an Underwriters Exemption is available, and should make sure that
the securities have investment grade ratings at the time of purchase, as that is a condition
for the continued protection of the Underwriters Exemptions.
The structuring and issuance of ABS and MBS are beyond the scope of this Handbook.
Managers seeking to engage in these activities for ERISA accounts should contact their
legal advisers.
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CHAPTER 20
ERISA-Restricted Securities
Certain securities, by their terms, are prohibited for purchase or holding by or transfer
to benefit plan investors, and are appropriately described as “ERISA-restricted.” Such
restrictions are often imposed in connection with the issuance of securities by a special
purpose vehicle or trust where the security is thought to have significant equity features.
Generally, issuers may impose ERISA restrictions out of a concern that the purchase or
holding of the security by ERISA plans may subject the issuer and its aliates to the
fiduciary and prohibited transaction requirements of ERISA. Blanket ERISA restrictions
are most often seen in fixed-income securities, particularly with respect to certain types
of loan participation notes.
Risks associated with ERISA-restricted securities came to the forefront in early 2014,
when the Department of Labor and the Securities and Exchange Commission fined an
asset manager $21 million for purchasing and holding ERISA-restricted securities on
behalf of certain ERISA clients. This enforcement action was unprecedented and caused
managers to review, and, in certain cases, amend their normal practices for researching
and purchasing certain types of securities. Many managers have, with assistance of
counsel, developed lists of types of securities that must be reviewed for ERISA restrictions.
Typically, securities that might be ERISA-restricted are accompanied by oering
documents, such as a prospectus or supplemental prospectus, oering memorandum
or private placement memorandum. It is typically within these oering documents that
one can find provisions restricting the purchase or holding of a security by benefit plan
investors. Oering materials that impose restrictions of this kind may state that purchasers
and transferees of the securities are “deemed” to represent that they are not benefit plan
investors. Such materials may also recite remedies that purportedly may be exercised by
the issuer in its discretion in the event of a breach of the deemed representation—for
example, nullifying the purchase or transfer as “void ab initio” or requiring that the
securities be transferred to a transferee of the issuer’s choice within a specified period of
time. These provisions can be complicated and are uncertain in their legal eect, and in
some cases may contradict other portions of the oering document.
In an eort to streamline the purchase and sale of these securities on the secondary market,
certain financial reporting services (e.g., Bloomberg) provide access to codes designating
whether securities are restricted or permitted for purchase by benefit plan investors.
Prior to the SEC’s and DOL’s enforcement action, some managers relied conclusively on
these designations in purchasing securities. Unfortunately, the designations are at times
incorrect. Accordingly, it is best practice for the manager or its counsel to review the
applicable oering documents without relying solely on financial reporting services.
Certain securities that are commonly ERISA-restricted include the equity and lower-
ranked tranches of CLOs, debt issued by special purpose vehicles that are not owned by the
guarantor, UCITS and other non-U.S. exchange-traded funds, low exercise price warrants
and certain non-U.S. issued debt. Oering documents should be carefully reviewed prior
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to purchasing securities of types that are commonly found to be ERISA-restricted. If after
review it is unclear whether the security is ERISA-restricted, it is advisable to contact
ERISA counsel for assistance. Counsel should also be contacted if it is discovered that
ERISA-restricted securities are being held or have been held on behalf of an ERISA client.
SAMPLE COMPLIANCE POLICY
Prohibition on purchase of ERISA-restricted securities
on behalf of ERISA accounts
When contemplating the purchase for an ERISA account of securities of a type designated by the Chief
Compliance Officer as potentially ERISA-restricted, the portfolio manager will ensure that the applicable
offering documents are reviewed to determine that the security is not prohibited from purchase or holding
by the ERISA account. If it is determined that a security is ERISA-restricted, the portfolio manager will
not purchase such security on behalf of the ERISA client.
If it is determined that the Firm has purchased and currently holds an ERISA-restricted security on behalf
of an ERISA client, the Firm will promptly notify the ERISA client of this fact.
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CHAPTER 21
Corrections
There are generally two methods for correcting transactions that violate ERISA. For
certain violations of the prohibited transaction rules, the statute provides 14 days to
correct the transaction. For breaches of fiduciary duty, including certain prohibited
transactions, the Department of Labor has adopted a Voluntary Fiduciary Correction
Program. This chapter explains which transactions may be corrected by these means and
how to correct those transactions.
Correcting a Prohibited Transaction
A fiduciary that has executed a nonexempt prohibited transaction involving the
acquisition, holding or disposition of any security or commodity (each as defined below)
may correct the transaction within 14 days of the date on which it discovers, or reasonably
should have discovered, that the transaction was prohibited under ERISA. Since the 14-
day period begins when the fiduciary “reasonably should have discovered” the violation,
it is advisable to set up a monitoring system to detect prohibited transactions.
To correct a transaction, the fiduciary generally must (i) undo the transaction to the
extent possible, (ii)make good to the plan any losses resulting from the transaction and
(iii)restore to the plan any profits made through the use of assets of the plan.
The 14-day correction period is not available if, at the time the transaction occurred, the
fiduciary knew, or reasonably should have known, that the transaction was prohibited
under ERISA. The correction period is also not available for transactions between a plan
and a plan sponsor or its aliates that involve the acquisition or sale of an employer
security, or the acquisition, sale, or lease of employer real property.
For purposes of this correction rule, a “security” means any (i) share of stock in a
corporation; (ii)partnership or beneficial ownership interest in a widely held or publicly
traded partnership or trust; (iii)note, bond, debenture or other evidence of indebtedness;
(iv) interest rate, currency or equity notional principal contract; (v) evidence of an
interest in, or a derivative financial instrument in, any security described above, or
any currency, including any option, forward contract, short position, and any similar
financial instrument in such a security or currency; and any position not described above,
or hedge, with respect to such a security.
For purposes of this correction rule, a “commodity” means (i) any commodity that
is actively traded; (ii) any notional principal contract with respect to any actively
traded commodity; (iii) any evidence of an interest in, or a derivative instrument in,
any commodity described in(i) or(ii), including any option, forward contract, futures
contract, short position and any similar instrument in such a commodity; and (iv)any
position or hedge with respect to such a commodity.
Correcting a Breach of Fiduciary Duty
A fiduciary that has breached a fiduciary duty to a plan may, in certain cases, voluntarily
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correct the transaction through the Voluntary Fiduciary Correction Program (VFCP).
Generally, the program requires that the fiduciary (i)identify any violations and determine
whether they are covered by the VFCP; (ii)undo the transaction, if possible; (iii)calculate
and restore any losses, profits, or supplemental benefits to the plan and participants; and
(iv)submit an application to the Department of Labor. Once the fiduciary satisfies the
terms of the program, the Department will issue a no-action letter for the transaction
in question. Pursuant to the no-action letter, the Department will not initiate a civil
investigation regarding the fiduciary’s responsibility for the transaction, or assess civil
penalties on the correction amount paid to the plan or its participants. However, the
Department may investigate to verify the facts set forth in the application and to confirm
that the transaction was corrected.
The following transactions, among others, may be corrected through the VFCP:
n
PURCHASE OF AN ASSET BY A PLAN FROM A PARTY IN INTEREST–Correction is available if a plan
purchased an asset with cash from a party in interest, in a transaction to which no
prohibited transaction exemption applies.
n
SALE OF AN ASSET BY A PLAN TO A PARTY IN INTEREST–Correction is available if a plan sold an
asset for cash to a party in interest, in a transaction to which no prohibited transaction
exemption applies.
n
PURCHASE OF AN ASSET BY A PLAN AT A PRICE MORE THAN FAIR MARKET VALUE–Correction is
available if a plan acquired an asset from a person who is not a party in interest without
determining the asset’s fair market value, and as a result the plan paid more than it
should have for the asset.
n
SALE OF AN ASSET BY A PLAN AT A PRICE LESS THAN FAIR MARKET VALUE–Correction is available if
a plan sold an asset to a person who is not a party in interest without determining the
asset’s fair market value, and as a result the plan received less than it should have from
the sale.
A fiduciary cannot participate in the VFCP if the fiduciary or the plan is under
investigation, unless the plan notifies the Department of Labor. A fiduciary or plan is
under investigation if it has received a notice that (i)the Department is conducting an
investigation of the fiduciary in connection with an act or transaction directly related
to the plan; (ii) any governmental agency is conducting a criminal investigation of
the fiduciary in connection with an act or transaction directly related to the plan;
(iii)the Pension Benefit Guaranty Corporation, any state attorney general, or any state
insurance commissioner is conducting an investigation or examination of the fiduciary in
connection with an act or transaction directly related to the plan; (iv) the Department is
conducting an investigation of the plan; or (v) the IRS is conducting an Employee Plans
examination of the plan. The VFCP also cannot be used if the Department has conducted
an investigation that resulted in the transaction’s referral to the IRS. Finally, the VFCP is
not available if the application contains evidence of potential criminal violations.
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After identifying and correcting a breach, the fiduciary must file an application with
the Department of Labor. If the fiduciary has a representative submit the application,
the application must include a signed statement that the representative is authorized to
represent the fiduciary. Plan assets may not be used for any fees paid to a representative
for preparing and submitting the application. The application must include specified
documentation relevant to the breach. The Department may request additional
documentation in writing from the fiduciary or authorized representative. The fiduciary
must maintain copies of the application and any subsequent correspondence with the
Department for six years after the filing date.
The Department of Labor will maintain the confidentiality of any documents submitted
under the VFCP, to the extent permitted by law. However, the Department has an
obligation to make certain referrals to the IRS, and to refer to other agencies evidence of
criminality and other information for law enforcement purposes.
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Appendix
Parties in Interest
ERISA Section 3 (14)
≥
50%
OWNED ENTITY
RELATIVE
RELATIVE
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
PLAN
≥
50%
OWNED ENTITY
SPONSORING
OR PARTICIPATING
EMPLOYER
≥
50% OWNER
≥
50%
OWNED ENTITY
FIDUCIARY
≥
50%
OWNED ENTITY
EMPLOYEE
ORGANIZATION
≥
50%
OWNED ENTITY
COUNSEL
≥
50%
OWNED ENTITY
EMPLOYEE
≥
50%
OWNED ENTITY
SERVICE
PROVIDER
RELATIVE
RELATIVE
RELATIVE
RELATIVE
Subsections of 3 (14)
A
B
C
D
E
F
G
H
I
19_1425_1104
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
EMPLOYEE,
OFFICER,
DIRECTOR
10%
S/H
10%
PARTNER/JV
