Investment managers face continued cross-trading limitations.

Given the proliferation of employee benefit plan transactions involving securities "cross-trades" (and related prohibited transaction exemption requests), the Department of Labor (DOL) is focusing additional scrutiny on these transactions. Specifically, on March 20, 1998, the DOL issued a notice indicating that it is seeking input in defining or redefining the standards and safeguards that should be required as a condition for exemptive relief.

At issue is the application of the Employee Retirement Income Security Act of 1974's (ERISA's) fiduciary and prohibited transaction rules, which prohibit a plan fiduciary from acting in any transaction involving a plan on behalf of a party whose interests are adverse to the interests of the plan or its participants and beneficiaries (ERISA Section 406(b)(2)). Normal plan operations often involve cross-trading transactions that technically violate these rules, even if no harm actually results to plan participants or beneficiaries.

The type of ERISA violation will depend, in part, on the nature of the cross-trade (i.e., whether it is a direct cross-trade or a brokered cross-trade). A direct cross-trade occurs when an investment manager causes the purchase or sale of a particular security to be made directly between two or more accounts under its management without using a broker as intermediary. A brokered cross-trade occurs when an investment manager places simultaneous purchase and sale orders for the same security with a broker-dealer under an arrangement that rewards the linkage with reduced broker commissions. Under ERISA, these transactions would trigger one or more ERISA violations if, for example, one of the accounts involved in the cross-trade is an employee benefit account and the investment manager has investment discretion with respect to both of the accounts involved; ERISA Section 406(b)(2) precludes an ERISA fiduciary from acting in a transaction involving a plan on behalf of a party with adverse interests; or the investment manager represents both the buyer and the seller in a cross-trade. ERISA Section 406(b)(2) precludes an ERISA fiduciary from acting in a transaction involving a plan on behalf of a party with adverse interests; ERISA Section 404(a) (1) (A) requires a fiduciary to discharge its duties solely in the interests of plan participants and for the exclusive purpose of providing benefits to such participants and beneficiaries; and ERISA Section 403 (c) (1) requires plan assets to be held for the exclusive purposes of providing benefits to plan participants and defraying reasonable plan administration costs.

Prior Exemptions

Given that cross-trades may be beneficial to employee benefit plans in some cases (e.g., such transactions typically provide lower transaction costs and better-than-market terms), the DOL has granted a number of individual exemptions from selected prohibited transaction rules (but not from any violations of ERISA Section 406(b)(1) or (b)(3) attributable to the investment manager's involvement on both sides of the deal or violations of the fiduciary requirements set forth in ERISA Sections 403 and 404). These individual exemptions fall into two categories: those for index or model-driven funds (in which trading decisions are generally passive or process-driven) and those for actively managed or discretionary asset management arrangements (in which the trading decisions are made by individuals hired to select securities for each account).

In addition, the DOL issued an earlier class exemption (PTCE 86-128) that generally provides relief where an investment manager has discretion with respect to, or provides investment advice to, either the buyer or seller, but not both.

Current Concerns

At present, the DOL is considering a number of individual exemption requests involving the purchase and sale of securities by employee benefit plans. To address possible abuses, the DOL issued the current notice to identify its concerns and seek input on whether, or with what constraints, those precedents should be continued or expanded.

While recognizing that cross-trading programs may provide some benefits to employee benefit plans (e.g., better terms than those available on the open market, reduced transaction costs, and the assurance that a counter party will be available for a proposed trade), the DOL still has some concerns about the protection of plan assets from fiduciary abuses. The DOL also has concerns about the potential for abuse in index and model-driven fund programs--which the DOL previously had considered as providing investment managers with limited investment discretion--stemming from the DOL's new understanding of the "subtle" exercise of discretion by investment managers permitted by such programs.

The concerns include the potential for the investment manager to:

* Place relatively liquid securities into ERISA accounts to (among other reasons) shift anticipated losses away from, or provide artificial liquidity and price stability for, favored accounts;

* Use ERISA accounts as buyers or sellers of securities at particular times to promote the interest of favored client accounts;

* Allocate favorable cross-trade opportunities (and the transaction cost savings associated with such cross-trades) to favored client accounts (e.g., those with a performance-based fee arrangement with the manager), to increase the manager's fees or demonstrate superior investment performance;

* Allow cross-trade opportunities to affect the underlying investment manager's decision on which securities to buy or sell for particular ERISA accounts; and

* Use cross-trades to avoid the potential market impact of large trades on certain accounts, when such trades may not be in the best interest of all accounts involved or may not result in the best execution for the acquisition or sale of such securities.

Given these concerns, the March 20 notice solicits input on a variety of issues related to plan transactions, and possible controls. The DOL questions, for example, whether it should consider developing a broad class exemption for cross-trading transactions, and whether it should adopt different standards for exemptions involving actively managed versus process-driven accounts. The notice also solicits information on a number of trading practices, including what impact the emergence of electronic systems might have on any exemption standards; whether there are real savings flowing to employee benefit plans from crosstrades not otherwise available in the market; what the transaction costs are for such off-market transactions; and whether cross-trades could be used to produce commercial advantages for the investment manager, etc.

Finally, anticipating input suggesting that the DOL rely on the methodology developed by the Securities and Exchange Commission (SEC) for cross-trades of equity and debt securities held in mutual funds, the notice clearly indicates the DOL's disinclination to adopt such standards. Noting that the mere determination of a fair and objectively determined price--which is the goal of the SEC standards--does not resolve ERISA concerns about fiduciary violations, the DOL declined to adopt the SEC standards set forth in SEC Rule 17a-7.

Comments were requested on or before May 19, 1998. While the DOL is now reviewing the voluminous responses to the notice, it has not scheduled any hearing or announced any timetable for release of the pending individual exemptions; nor has it made any decision to initiate a new class exemption (no request is currently pending). In the interim, plans and investment managers involved in such trades may continue to rely on previously granted individual or class exemptions (if relevant) or, if not covered by those exemptions, request an individual exemption.