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Guest Article

(From the February 19, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

DOL Guidance on Cross-Trading Prohibited Transaction Exemption

The Department of Labor's Employee Benefits Security Administration (EBSA) has issued interim final rules on the content requirements for written cross-trading policies and procedures that ERISA plan investment managers must adopt before taking advantage of the new cross-trading prohibited transaction exemption. 72 FR 6473 (February 12, 2007). The interim final rules do not establish any compliance burdens for employers and plan administrators; however, employers, plan administrators, and other plan fiduciaries should be aware of these content requirements because they will have to review investment managers' cross-trading policies and procedures before deciding whether their plans will participate in cross-trading programs. Although mostly relevant to retirement plans, the cross-trading prohibited transaction exemption could apply with respect to any ERISA plans -- including funded health and welfare plans.

Overview of Cross-Trading Prohibited Transaction Exemption

The Pension Protection Act (PPA) of 2006 (P.L. 109-280) amended ERISA to create a prohibited transaction exemption for cross-trades, which is defined as "the purchase and sale of a security between a plan and any other account managed by the same investment manager." The transaction fees associated with these cross-trades generally are lower than trades executed in the open market, and so they can be more cost-effective for the buyer and seller. However, absent a prohibited transaction exemption ERISA plan assets could not be involved in cross-trades because the investment manager is a party in interest with respect to the plan.

One concern about cross-trading is that the investment manager may not adequately protect the best interests of all parties to the transaction. Thus, the new cross-trading prohibited transaction exemption -- which is effective for transactions occurring after August 17, 2006 -- is conditioned upon satisfying a number of specific requirements designed to ensure the interests of any ERISA plan(s) involved are protected. These requirements are --

the transaction is a purchase or sale, for no consideration other than cash payment against prompt delivery of a security for which market quotations are readily available;
the transaction is effected at the independent current market price of the security;
no brokerage commission fee (except for customary transfer fees, the fact of which is disclosed) or other remuneration is paid in connection with the transaction;
a fiduciary (other than the investment manager engaging in cross trades or any affiliate) for each plan participating in the transaction authorizes in advance of any cross trades (in a document that is separate from any other written agreement of the parties) the investment manager to engage in cross trades at the investment manager's discretion, after the fiduciary has received disclosure regarding the conditions under which cross trades may take place (but only if the disclosure is separate from any other agreement or disclosure involving the asset management relationship), including the written policies and procedures of the investment manager;
each plan participating in the transaction has assets of at least $100,000,000, except that, if the assets of a plan are invested in a master trust containing the assets of plans maintained by employers in the same controlled group, the master trust has assets of at least $100,000,000;
the investment manager provides to the plan fiduciary who has authorized cross trading a quarterly report detailing all cross trades executed by the investment manager in which the plan participated during such quarter, including the following information as applicable: the identity of each security bought or sold, the number of shares or units traded, the parties involved in the cross trade, and the trade price and the method used to establish the trade price;
the investment manager does not base its fee schedule on the plan's consent to cross trading and no other service (other than the investment opportunities and cost savings available through a cross trade) is conditioned on the plan's consent to cross trading;
the investment manager has adopted, and cross trades are effected in accordance with, written cross-trading policies and procedures that are fair and equitable to all accounts participating in the cross-trading program and that include a description of the manager's pricing policies and procedures, and the manager's policies and procedures for allocating cross trades in an objective manner among accounts participating in the cross-trading program; and
the investment manager has designated an individual responsible for periodically reviewing purchases and sales to ensure compliance with the written policies and procedures and, following such review, the individual must issue an annual written report no later than 90 days following the period to which it relates, signed under penalty of perjury, to the plan fiduciary who authorized the cross trading, describing the steps performed during the course of the review, the level of compliance, and any specific instances of noncompliance.

Interim Final Rules

The interim final rules specify the content requirements for the written cross-trading policies and procedures investment managers must adopt before using the cross-trading exemption. As a general matter, the interim final rules require the policies and procedures "must be clear and concise and written in a manner calculated to be understood by the plan fiduciary authorizing cross-trading." Additionally, the information included in the policies and procedures "must be sufficiently detailed to facilitate a periodic review by the compliance officer of the cross-trades and a determination by such compliance officer that the cross-trades comply with the investment manager's written cross-trading policies and procedures." Specifically, the written policies and procedures must include the following:

A statement of policy which describes the criteria that will be applied by the investment manager in determining that execution of a securities transaction as a cross trade will be beneficial to both parties to the transaction;
A description of how the investment manager will determine that cross trades are effected at the "independent current market price" of the security, including the identity of sources used to establish such price;
A description of the procedures for ensuring compliance with the $100,000,000 minimum asset size requirement;
A description of how the investment manager will mitigate any potentially conflicting division of loyalties and responsibilities to the parties involved in any cross-trade transaction;
A requirement that the investment manager allocate cross trades among accounts in an objective and equitable manner and a description of the allocation method(s) available to and used by the investment manager for assuring an objective allocation among accounts participating in the cross-trading program. If the investment manager may use more than one methodology, a description of what circumstances will dictate the use of a particular methodology;
Identification of the compliance officer responsible for periodically reviewing the investment manager's compliance with the written policies and procedures and a statement of the compliance officer's qualifications for this position; and
A statement describing the scope of the compliance officer's review.

Effective Date and Comments

The PPA directed the Labor Secretary to issue regulations regarding the content of an investment manager's cross-trading policies and procedures by February 13, 2007. The interim final rules satisfy that mandate. However, DOL is accepting comments on the interim final rules until April 13, 2007 -- the same day the interim final rules will take effect. The DOL intends to issue final regulations after it has had a chance to review and consider any comments it receives.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879-5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

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