Derivatives

[Guest research]

I recently have been looking at the ERISA plan asset issues that arise when a plan enters into a derivative contract whereby the investment return to the plan is indexed, in part, to investments held by the counterparty to the derivative contract. The derivative is a type of equity swap (not a total return swap) which would mix and match the returns on several reference hedge fund interests owned by the counterparty. The returns are mixed and matched in a complicated manner so as to match investment diversification goals desired by the plan in order to diversify risks in the plan's investment portfolio. As such, the derivative contract is not a total return swap but rather returns (and losses) to the plan are determined based on a formula that takes into account various apsects of the gain or loss on the hedge fund interests held by the counterparty.

Under paragraph (g) of the plan asset regulations, where a plan jointly owns property with others, or where the value of a plan's equity interest relates solely to identified property of the entity, such property is treated as the sole property of a separate entity. Example 10 in the plan asset regulations involves a plan that acquires a 30% participation in a debt instrument that is held by a bank. The example states that since the value of the participation certificate relates solely to the debt instrument, the debt instrument is, under paragraph (g) of the plan asset regulations, treated as the sole asset of a separate entity. Since the benefit plan investor in Example 10 owns 25% or more of the value of the equity interest in the deemed separate entity (i.e., the participation certificate), the look-through rule under the plan asset regulations applies and the plan's assets are deemed to include the participation certificate and an undivided interest in the debt instrument. Consequently, the bank becomes a fiduciary with respect to the plan and the bank's actions with respect to the debt instrument are subject to ERISA's prohibited transaction rules of ERISA.

Depending how derivative contracts are structured, a similar result may apply to the property held by the coutnerparty thereby subjecting the counterparty to ERISA fiduciary and prohibited transaction rules. There appears to be little published authortiy concerning the application of the plan asset regulations to derivative contracts. I would be intersted in hearing from anyone who is aware of any authority or articles on the issue (or similar types of contracts). Thanks.