450 Lexington Avenue New York, NY

Transcription

1 450 Lexington Avenue New York, NY Date: August 17, 2006 To: From: Interested Persons Davis Polk & Wardwell Re: Pension Protection Act of 2006 Today the President signed into law the Pension Protection Act of 2006 (the Pension Act ). Most of the provisions of the 900-page Pension Act focus on reforms to the structure, funding and insurance of U.S. pension plans, but the legislation also includes a number of provisions amending the fiduciary duty rules of the Employee Retirement Income Security Act of 1974 (ERISA) and the prohibited transaction rules of ERISA and the Internal Revenue Code of 1986 (IRC). These provisions are cast largely in the form of statutory exemptions which remove a variety of obstacles that have hampered trading and investments by retirement plans. These exemptions are effective immediately, with the exception of the investment advice exemption (described at the end of this memo), which is effective beginning January 1, This memorandum summarizes the relevant exemptions as set forth in the Pension Act, but the reader should be aware that these exemptions are subject to any technical corrections that may be adopted by Congress and any guidance that may be issued by the Department of Labor (DOL). 1. Changes to the Plan Asset 25% Test Background Unless an exception applies, when an ERISA plan invests directly or indirectly in a private investment fund, the plan s assets include a proportional undivided interest in each asset held by the fund. The fund manager is deemed an ERISA fiduciary with respect to that portion of the assets, and any transactions involving that portion of the assets will be subject to the prohibited transaction rules of ERISA. Under existing DOL rules, one exception that a fund can use to avoid this result is to ensure that benefit plan investors in the fund do not hold 25% or more of any class of equity interests in the fund. The 25% exception is critical to hedge funds, which typically cannot qualify for other exceptions available to operating companies, registered issuers, registered investment companies and funds that operate as venture capital operating companies (VCOCs) and real estate operating companies (REOCs). The Pension Act includes a brief but important plan asset provision, which modifies the 25% exception in two respects. New Rule Limiting the Plans Included in the 25% Test The Pension Act provides that assets of an investment entity will not be treated as plan assets if less than 25% of each class of equity interests in the entity are held by benefit plan investors. For these purposes, the term benefit

2 plan investor includes ERISA plans, IRAs and entities in which ERISA plans and IRAs hold 25% or more of any class of equity interests. However, federal, state and local governmental plans, non-u.s. plans and church plans will no longer be counted against the 25% limit. New Look-Through Rule The new plan asset provision also seems to provide a favorable answer to a recurring question under the plan asset rules: When a fund of hedge funds ( Fund A ) has a class of limited partner interests which are held 30% by ERISA plans, and Fund A seeks to invest in another fund ( Fund B ), for purposes of its 25% test, should Fund B count the entire investment by Fund A as a benefit plan investment or should Fund B count only a percentage of Fund A s investment equal to the percentage of the overall ERISA plan investment in Fund A? The new plan asset provision states that [a]n entity shall be considered to hold plan assets only to the extent of the percentage of the equity interest held by benefit plan investors. Although the import of this clause could have been made more clear, it appears to mean that, in the scenario above, Fund B should look-through Fund A and count as a benefit plan investment only 30% of Fund A s investment in Fund B. This look-through counting will be beneficial not only for funds of funds, but for a variety of master-feeder and multi-fund structures that are commonly used by hedge fund managers. Proposed Changes That Were Not Included There were efforts to include several other changes, such as eliminating class-by-class application of the 25% test, raising the limit to 50%, and adding language that would make clear that, in performing the 25% test, non-plan client money directed into a fund by the fund manager or an affiliate could be counted in the denominator for the fund s 25% test. Although these provisions ultimately failed to make it into the legislation, a DOL advisory committee is continuing to study these issues. Implications of the Changes A number of hedge funds are already bumping up against the 25% limit based on ERISA plan demand alone, but for many funds the new rule will open significant additional capacity by allowing funds to accept unlimited investment by governmental and non-u.s. plans and utilize their 25% reserve wholly for ERISA and IRA investors. This additional capacity will be particularly encouraging for funds of hedge funds seeking to invest in high performing third-party funds that intend to remain under the 25% limit, as it will open opportunities for investment in these third-party funds. But in order to invest in these third-party funds, a fund of funds may be required to keep the third-party funds apprised of the level of ERISA and IRA participation in the fund of funds. Many funds have not previously distinguished between ERISA plan investors, governmental plans and non-u.s. plans and may have to develop procedures for getting this information and keeping it current. Other types of investment pools, such as issuers of asset-backed securities and other specialpurpose vehicles (SPVs), have typically excluded benefit plan investors entirely from any equity class of interests in the pool because these entities cannot monitor the 25% limit, particularly if the equity class is transferable in a secondary market. However, a limited, but possibly growing, number of asset pools and SPVs have been considering ways to use the 25% limit. This is seen, for example, when equity interests in an asset pool or SPV are offered on a limited basis in the U.S. under Rule 144A and on a broader basis outside the U.S., with secondary trading on a non- U.S. market. In this case, the two methods that have been used to avoid ERISA are to: (1) declare that ERISA investors may not purchase the equity interests or (2) create a separate series 2

3 of interests equal to 25% of the publicly traded equity interests and permit benefit plan investors (ERISA and non-erisa) to hold only that series. This second approach can now be modified to permit non-erisa plans to purchase as much of the fund s interests as they wish and to limit only ERISA investors to the separate 25% series of interests. Some underwriters have been considering approaches to monitor plan investment in an otherwise publicly traded security (e.g., using a depository receipt program for plan investors or requiring plan investors to subscribe directly to an appointed agent for interests). So far, the drawbacks of these approaches have outweighed the benefits, but it remains to be seen whether these approaches will gain appeal now that they need only be applied to U.S. ERISA and IRA investors, rather than to all benefit plan investors. Finally, the 25% test might offer additional latitude for certain private equity and real estate funds that would otherwise have used the VCOC or REOC exception to avoid ERISA. The VCOC or REOC exceptions require constant monitoring of a fund s investments to ensure that at least 50% of the fund s portfolio meets the conditions specified under the VCOC and REOC rules. A fund which meets the new 25% test can avoid this constant monitoring. Accordingly, a fund manager raising a new private equity or real estate fund should draft the fund documents to provide flexibility to use the 25% exception if the fund can meet the new 25% test, and managers of existing funds should review their investor lists and the terms of their funds to determine whether they can possibly use the new 25% test in lieu of complying with the VCOC or REOC exception. 2. Service Provider Exemption Background The ERISA prohibited transaction rules forbid virtually all transactions between a plan and a party in interest to the plan, a term which includes any service provider to the plan and any 10% parent or 50% subsidiary of the service provider. Therefore, unless an exemption applies, a plan cannot enter into a derivative transaction with a broker-dealer, or purchase debt securities issued by the broker-dealer, if the broker-dealer might separately provide services to the plan. The provisions of ERISA and the various DOL prohibited transaction class exemptions (PTCEs) provide relief for an assortment of transactions between plans and parties in interest, provided that the transactions are directed by a fiduciary independent from the party in interest and meet certain other specified conditions. These exemptions include: the ERISA Section 408(b)(2) services exemption, PTCE 75-1 covering principal trades and margin lending, PTCE covering transactions directed by a qualified professional asset manager (QPAM), PTCE 90-1 covering transactions by insurance company separate accounts, PTCE covering transactions by bank collective trusts, PTCE covering transactions by insurance company general accounts and PTCE covering transactions directed by an in-house asset manager (INHAM). However, plans and financial service providers have questioned why a transaction with a service provider should have to meet the conditions of these exemptions if the transaction is executed on arm s-length terms by a plan fiduciary who is independent of the service provider. 3

4 New Service Provider Exemption The Pension Act includes a new statutory exemption from the prohibited transaction rules of ERISA and the IRC for transactions between plans and parties in interest, which applies where: the transactions involve a (1) sale, exchange or leasing of property (including securities and commodities), (2) loan or other extension of credit or (3) transfer to, or use by, a party in interest of any plan assets, neither the party in interest or an affiliate is a fiduciary who has discretionary authority with respect to the investment of the plan assets involved in the transaction, and the party in interest is a party in interest with respect to those assets solely by reason of providing services to the plan or by reason of an affiliation with a service provider to the plan, and the plan receives no less or pays no more than adequate consideration in connection with the transaction. For transactions involving the purchase or sale of a market-traded asset, the term adequate consideration is based on the prevailing market price (taking into account the size of the transaction and existing liquidity), and for a non-market-traded asset, adequate consideration is the fair market value of the asset determined in good faith by a fiduciary in accordance with regulations prescribed by the Labor Secretary. ERISA has historically applied an adequate consideration standard to the pricing of purchases and sales of employer-sponsor securities and real property between a plan and the employer-sponsor of the plan. For these purposes, the DOL issued proposed regulations in 1988, which provide that with respect to a non-market-traded asset, adequate consideration will be the fair market value of the asset determined either by an independent fiduciary or by an appraisal performed by an independent third-party appraiser. Although these regulations have never been made final, the standard under the proposed regulation would be easy to meet in the context of the new service provider exemption. By its terms the service provider exemption requires that the fiduciary effecting the relevant transaction for a plan be independent of the plan service provider on the opposite side of the transaction. Thus, under the DOL s proposed regulation, the adequate consideration requirement can be met with a determination of fair market value by the plan fiduciary making the trade for the plan. But it remains to be seen whether the DOL will issue different or additional guidance as to the meaning of adequate consideration in light of the new service provider exemption. Affected Arrangements While the service provider exemption should significantly simplify the analysis and the terms relating to many common investment transactions, there is some initial confusion regarding the requirement that the party in interest involved in a transaction not possess or exercise discretionary authority or control with respect to the investment of the plan assets involved in the transaction. The question that has been raised is: If a manager or financial institution has control over plan assets and delegates to a second unaffiliated manager the responsibility and discretion to manage a portion of those plan assets, may the second fiduciary rely on the service provider exemption to engage in transactions with the original manager or financial institution or its affiliates? 4

5 A quid pro quo between the two managers would clearly be prohibited under the basic fiduciary duty rules of ERISA. However, if the second manager transacted with the original manager or its affiliates as part of the second manager s ordinary course of trading, this would not be contrary to the basic fiduciary duty rules of ERISA and would appear to be within the intended scope of the service provider exemption, assuming that the original manager has given the second manager exclusive authority or control with respect to decisions regarding the investments and transactions to be executed with the relevant plan assets. Like the service provider exemption, the DOL s QPAM exemption requires a manager engaging in a transaction to make its own investment decisions and negotiate the terms of the transactions, but the QPAM exemption also contains specific additional conditions that apply in cases where a manager seeks to transact with another party who has appointed the manager. Arguably, if Congress had intended that the service provider exemption be subject to similar conditions it would have made those conditions explicit, as the QPAM exemption does. Assuming that the ERISA community can come to agreement that the broader reading of the service provider exemption is appropriate, which might be an ambitious assumption, the service provider exemption should allow the terms of many typical investments to be streamlined by eliminating reliance on the patchwork of the existing PTCEs and relying wholly on the more simple service provider exemption. Therefore, to the extent that this view gains a consensus, and certainly in cases where it is clear that the manager effecting a transaction with a service provider has not been appointed by the service provider (or its affiliates), the ERISA provisions of the following arrangements can be simplified: Prime Brokerage. Prime brokerage arrangements between a broker-dealer and a plan or a hedge fund containing plan assets will no longer require provisions ensuring compliance with a PTCE (e.g., the QPAM exemption), because, although the prime broker might be a service provider to the relevant plans, the new service provider exemption, coupled with the existing statutory exemption covering services to plans, would encompass all of the transactions envisaged by a typical prime brokerage relationship, including extensions of credit and loans of securities by the prime broker and its affiliates to cover short sales as well as foreign exchange trades with the prime broker and its affiliates. ISDA Masters and Transactions. From an ERISA perspective, ISDA trades have typically been viewed as consisting of notional sales or exchanges of assets and an embedded extension of credit, both of which are exempt under the new service provider exemption. Thus, the documentation for these transactions can now omit reliance on the various PTCEs that used to be required by ISDA dealers. Notes, Warrants and Other Structured Products. The new service provider exemption would also exempt the issuance and sale by financial service firms of notes, warrants and other structured products, whether these instruments are sold under a registered program or an exempt program (e.g., Rule 144A, Reg D or Section 3(a)(2)). This includes straight operating debt and structured products issued by financial firms, such as the wide variety of medium-term notes and structured derivative products on the market (i.e., equity-linked products, basket and index-linked products, commodity-linked products, currency-linked products, hedge fund-linked products, etc.). Again, 5

6 the documentation relating to these offerings can now omit reference to the various PTCEs previously required for the sale of these products to ERISA and IRA investors. Securities Lending and Borrowing. Securities lending by plans was previously permitted under a specific securities lending class exemption (PTCE 81-6), while securities borrowing by plans was eligible for exemption under the QPAM exemption and the other broad-based PTCEs. The new service provider exemption will presumably replace these exemptions in the securities lending and borrowing context. Broker-dealers sometimes enter into exclusive borrowing arrangements with plans giving the broker-dealer sole access to borrow securities held by the plan. These arrangements might continue to require a separate individual exemption from the DOL, but this is worthy of further consideration. Repos and Reverse Repos. Repurchase arrangements, in which a plan buys a security pursuant to an agreement to return the security at a later date in exchange for repayment of the cash purchase price have traditionally been exempt under a specific repo exemption included in PTCE Reverse repurchase arrangements, in which the plan sells securities subject to an agreement to repurchase them at a later date, were eligible for exemption under the QPAM exemption and the other broad-based PTCEs. Again, the new service provider exemption will presumably replace these exemptions. Non-U.S. Trading, Margin Lending and Securities Lending. Under the existing rules, the primary class exemptions used for principal trades, margin lending and securities borrowing between plans and U.S. broker-dealers do not apply to broker-dealers that are not registered under U.S. securities laws. The DOL has extended exemptions to broker-dealers and banks in several non-u.s. jurisdictions, but the new service provider exemption will make these exemptions unnecessary and will allow these transactions regardless of the location or registered status of the institution on the other side of the transaction. Continuing Implications In all of the foregoing transactions, a financial service firm might still require documented terms making clear that the firm is not acting as a fiduciary to the relevant plan counterparty with respect to the assets involved in the transaction and may now even include an actual or deemed acknowledgement by the plan investor that the transaction is for adequate consideration. Although these elements are questions of fact, financial firms will presumably expect these points to be addressed in the transaction documents. 3. Cross Trades Background Historically, the prohibited transaction rules of ERISA and the IRC have been interpreted to bar an investment manager from causing a sale or exchange of a security between two managed accounts or funds when a plan investor was on either or both sides of the trade. In the DOL s view, this prohibition applied even when the cross trade could be executed at a reliable market quote and the plan investors would benefit from a prudent transaction executed without commissions or trade fees. In recent years, the DOL issued limited PTCEs and 6

7 individual exemptions covering passive and model-driven cross trades involving plans, and the DOL had been considering requests for broader relief. However, the Pension Act includes a provision that will provide significant additional relief for cross trades and may be relied upon for both passive and active cross trades. New Exemption for Cross Trades The Pension Act includes a new statutory exemption for any transaction involving the purchase and sale of a security between a plan and any other account managed by the same investment manager, provided that: the transaction is a purchase or sale for 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 or fee is paid in connection with the transaction, in advance of the first cross trade for the plan, an independent fiduciary of the plan is provided disclosure regarding the conditions under which cross trades may take place and executes an authorization permitting the manager to engage in cross trades at the manager s discretion (the disclosure and authorization must be in documents separate from the other documents relating to the management relationship), the investment manager does not vary its fee schedule or condition its services on the basis of whether the plan consents to cross trading, the plan has assets of at least $100 million, except that in the case of a master trust covering several plans of a single employer or controlled group the total assets of the trust may be considered in meeting the $100 million minimum, the manager provides to the independent plan fiduciary a quarterly report detailing all cross trades executed for the plan, indicating the identity of each security and counterparty involved, the number of shares or units traded, and the trade price and the method used to establish the trade price, the manager executes cross trades in accordance with written cross trading policies and procedures that are fair and equitable to all accounts participating in the cross trading program, and includes a description of the manager s pricing policies and procedures for allocating cross trades in an objective manner among accounts (the exemption directs the DOL to consult with the SEC and issue regulations regarding the content of the required policies and procedures), and the manager has designated an individual to periodically review cross trades to ensure compliance with the written policies described above and procedures and to issue annually a written report to independent plan fiduciaries describing the steps performed during the course of the review, the level of compliance, and any specific instances of non-compliance, and notifying the plan fiduciary of its right to terminate participation in cross trading at any time. 7

8 The cross trading exemption covers the purchase and sale of a security between a plan and any other account managed by the same investment manager. A manager would be permitted to use an affiliated broker-dealer to execute a cross trade if necessary, provided that the broker-dealer did not charge commissions or fees, other than previously disclosed customary transfer fees. Under a separate and long-standing exemption provided by PTCE , an affiliated brokerdealer may charge commissions for executing cross trades between two accounts, but only if the related manager has trading discretion solely with respect to one side of the trade (not both sides) and a number of other conditions are met. PTCE will presumably remain available when a manager and its affiliates do not have discretion with respect to both sides of a cross trade. But in situations involving a manager-directed transfer of securities from one managed account to another, the new cross trading exemption will be the exclusive source of relief. Because the new exemption requires the two accounts involved in a cross trade to be managed by the same manager, at least under a technical reading, the exemption does not appear to cover a trade between two accounts or funds managed by different but affiliated managers. Managers of hedge funds and other pooled accounts would welcome an exemption that would permit them to reallocate securities between two or more of their managed funds when this might be beneficial to investors. However, if one or more of the funds involved is subject to ERISA, the conditions of the cross trade exemption would have to be met, including the conditions requiring that: (1) every plan in the relevant ERISA fund would have to have at least $100 million of total plan assets, (2) all of the participating plans in the ERISA fund would have to receive the detailed disclosure and reports required under the exemption, including quarterly reports listing all cross trades and (3) every plan in the ERISA fund would have to consent to allow the manager to execute reallocations at its discretion. If a single plan refused or withdrew its permission to allow reallocations, the cross trade exemption would not apply. Plan investors could not be forced to consent because the exemption would not apply if a manager refuses to provide services to plan investors who fail to authorize cross trading. 4. Electronic Trading Systems Background The original legislative history of ERISA indicates that blind trades through a securities exchange were not intended to be prohibited merely because a plan and a party in interest might end up on opposite sides of the trade. However, the evolution of electronic communication networks (ECNs), alternative trading systems (ATSs) and similar off-exchange trading systems has presented a host of unanswered questions. Unlike exchanges, some of these systems execute trades on a partially disclosed basis (i.e., at some point each trading party knows or could ascertain the identity of its counterparty). In some cases the system acts in a role similar to a riskless principal in executing trades. And in some cases, the volume on a system (particularly a new system) is limited, enabling a plan investment manager to be aware that the trades routed to the system by the manager and its affiliates could account for a significant portion of the system s trading volume in particular issues. The system may in fact be owned by a consortium which includes an affiliate of the investment manager. However, these issues should not result in abuses because a manager trading for a plan is subject to a duty of best execution, and trades on these systems are typically executed pursuant to a best price match or a price which is electronically negotiated using the trading system. 8

9 The DOL has issued an advisory opinion condoning the use of an ATS, but the exemption was premised on a specific set of facts and conditions, including a requirement that the plan fiduciary effecting the trade not be aware of the identity of the counterparty prior to the execution of the trade. New Exemption for ECNs and Other Trading Systems The Pension Act includes a new statutory exemption, which exempts any transaction involving the purchase or sale of securities (or other kinds of property approved by the DOL), between a plan and a party in interest if executed through an ECN, ATS, or similar execution system or trading venue subject to regulation and oversight by the applicable federal regulating entity, or such non-u.s. regulatory entity as the DOL may approve by regulation, provided that: neither the execution system nor the parties to the transaction take into account the identity of the parties in the execution of trades, or the transaction is effected pursuant to rules designed to match purchases and sales at the best price available through the execution system, the price and compensation associated with the purchase and sale are not greater than the price and compensation associated with an arm s-length transaction with an unrelated party, if the party in interest has an ownership interest in the trading system, the system has been authorized by the plan sponsor or other independent fiduciary for transactions described in this paragraph, and not less than 30 days prior to the date that a transaction involving a plan is first executed on a particular system, an independent fiduciary of the plan is provided written or electronic notice of the investment manager s intention to use the system. Provided that the above conditions are met, the exemption will apparently apply to trades on the given system between a plan and any party in interest, including a party related to the plan investment manager directing the trade or any other party in interest to the plan. This exemption covers the use of ECNs, ATSs and similar systems subject to oversight by U.S. federal regulators (e.g., the SEC). Some of the existing U.S. regulated trading systems facilitate trading in both U.S. and non-u.s. securities, but trading systems operated outside the U.S. without oversight by U.S. regulators will not be covered by the exemption unless the DOL extends the exemption to the relevant jurisdiction. 5. Block Trades Background Investment managers seeking to purchase or sell a large block of the same security or commodity for several managed accounts may obtain better terms if the block is moved in a single transaction, but when the account of a plan client is included in the trade, the manager may be prohibited from executing the trade through a particular broker-dealer or futures commission merchant, if, for example, the broker or merchant is an affiliate of the manager and 9

10 an exemption does not apply or, as is common in commodities trades and in securities trades on non-u.s. markets, the block trade is privately negotiated with a counterparty who might potentially be a party in interest to the plan participating in the trade. The QPAM exemption and the other broad-based PTCEs are helpful in many but not all cases. In the absence of an exemption, there is a risk of a prohibited transaction even when a plan constitutes only a small portion of the block trade. Separating the plan s portion out of the larger trade might create competing tensions, such as concerns over whether the plan trade will get inferior terms and the risk that the larger part of the trade will front-run the plan trade or, if delayed, will suffer from an interim market movement. New Exemption for Block Trades The Pension Act includes a new statutory exemption for block trades executed between a plan and any party other than a fiduciary to the plan, provided that no plan for which the trade might involve a prohibited transaction has an interest of more than 10% in the transaction (alone or together with other plans of the same plan sponsor). For these purposes, the term block trade bears the standard U.S. market definition a trade of at least 10,000 shares or with a market value of at least $200,000. The exemption is subject to the typical exemption conditions requiring that the trade be on arm s-length terms and the commission and fees be comparable to similar trades. Unlike other exemptions in the Pension Act, the block trade exemption does not apply to trades between a plan and any fiduciary to the plan, even if the fiduciary has no responsibility for the investment of the assets involved in the trade. Moreover, by its terms, the block trade exemption applies to trades of securities, or other property (as determined by the [Labor] Secretary). Thus, it applies to trades involving stocks and bonds in the U.S. and overseas, but will not apply to commodities trades unless the DOL acts to expand the exemption. 6. Foreign Exchange Transactions Background Foreign exchange ( forex ) trades are typically executed on a principal basis by banks and currency dealers. Since most currency dealers and banks assume that they might be service providers (i.e., parties in interest) to any given plan, they will only execute forex trades with plans pursuant to an applicable exemption, such as the QPAM exemption or another of the broad-based PTCEs. Most forex trades on behalf of U.S. plans are executed in connection with plan transactions in non-u.s. securities. But even when a U.S. QPAM has directed the securities transaction necessitating the forex trade, given the manner in which forex trades are executed in the various local markets and the time-zone challenges, in many instances the QPAM will not have an opportunity to approve the final rate or terms of the forex trade, rendering the QPAM exemption potentially inapplicable. The DOL has offered limited relief in two PTCEs for forex trading, but the conditions of these PTCEs have proven impossible in many, if not most, situations. New Exemption for Forex Transactions The Pension Act includes a new statutory exemption for forex trades executed in connection with securities transactions. This exemption applies to any forex trade between a bank or broker-dealer (or any affiliate of either) and a plan with respect to which the bank or broker-dealer (or affiliate) is a trustee, custodian, fiduciary, or other party in interest, provided that: 10

11 the forex trade is in connection with the purchase, holding, or sale of securities or other investment assets (other than currency trading unrelated to any other investment in securities or other investment assets), the bank or broker-dealer (or any affiliate of either) does not have investment discretion, or provide investment advice, with respect to the transaction, at the time the forex trade is entered into, the terms of the trade are not less favorable to the plan than the terms generally available in comparable arm s-length forex trades between unrelated parties, or the terms afforded by the bank or broker-dealer in comparable arm s-length foreign exchange transactions involving unrelated parties, and the exchange rate used by the bank or broker-dealer for a particular forex trade does not deviate by more or less than 3 percent from the interbank bid and asked rates for trades of comparable size and maturity at the time of the trades as displayed on an independent service that reports rates of exchange in the relevant currency market. The exemption covers forex transactions in connection with the purchase, sale and holding of securities and other assets and, accordingly, should cover forex trades to convert interest and dividends on investments, as well as forex contracts purchased to hedge currency risk directly associated with assets held for investment. It appears that the forex exemption and the service provider exemption (described earlier) are equally available for forex transactions. The service provider exemption applies an adequate consideration standard and covers a broad range of forex trading, including trading that is not related to securities positions, whereas the forex exemption applies the 3% test described above, but covers only forex trades coincident with securities trading by a plan investor. The overlap between the service provider exemption and the forex exemption is probably the result of lobbying efforts to ensure forex relief in the event that the service provider exemption was not included in the final legislation. 7. Inadvertent Principal Trades Background One of the most common and most draconian applications of the prohibited transaction rules is when a broker-dealer mistakenly executes a securities trade on a principal basis for a pension plan account managed by an affiliated investment manager. PTCE 75-1 and the new service provider exemption would permit this if the broker were not affiliated with the manager directing the trade. But where the broker and the manager are affiliated, principal trades are prohibited. When such trades occur due to an oversight, even if they are reversed within days, a prohibited transaction excise tax is due equal to 15% of the amount of the trade. New Relief Permitting Timely Correction of Prohibited Purchases and Sales of Securities or Commodities The Pension Act includes a new statutory exemption for prohibited transactions involving the acquisition, holding or disposition of any security or commodity, which will allow parties in interest to avoid excise taxes on these transactions, provided that: 11

12 the transaction is not a transaction between a plan and the plan sponsor involving securities of the sponsor or an affiliate, the party in interest who has engaged in the prohibited transaction with the plan neither knew nor reasonably should have known at the time of the transaction that the transaction violated the prohibited transaction rules, and the transaction is corrected within 14 days after the party in interest discovers or reasonably should have discovered that the transaction was prohibited. A correction requires a reversal of the transaction, to the extent possible, and a return to the plan of any losses suffered by the plan and any profits made by the party in interest. This exemption applies with respect to prohibited transactions which a party in interest discovers, or reasonably should have discovered, at any time after the Pension Act is signed into law, even if the transactions occurred prior to enactment of the Pension Act. 8. Bonding Background With certain exceptions, the rules under ERISA require all parties who handle plan assets to be covered by a bond ensuring against losses caused by fraud or dishonesty. The coverage must be in an amount not lower than the lesser of 10% of plan assets handled or $500,000 per plan. ERISA exempts most U.S. banks, trust companies and insurance companies from the bonding requirement. DOL regulations separately exempt U.S. registered brokerdealers from bonding with respect to plan assets for which they merely execute trades and do not perform other functions, such as custodial services. Since many broker-dealers do more than merely execute transactions for plans, the existing DOL exemption falls short. Although brokerdealers are subject to a general bonding requirement under NASD rules, the ERISA bonding requirement has proven impossible for broker-dealers because it is difficult for large brokerdealers to keep track of the level of assets in accounts that are plan assets, particularly when plan accounts include hedge fund assets and other commingled assets that only partially consist of plan assets. New Bonding Exemption The Pension Act includes a new statutory exemption from the ERISA bonding rules for broker-dealers that are registered under the Securities Exchange of Act of 1934 and subject to fidelity bonding requirements of a self-regulatory organization. This exemption from bonding will apply with respect to a plan for the plan s plan year beginning after August 17, 2006, the date that the Pension Act was signed into law, which may cause some confusion because broker-dealers generally do not keep track of the plan year start dates for plan customers and certainly not for plans that participate in hedge funds. The bonding relief applies only to broker-dealers who registered under the Exchange Act and, therefore, will not provide relief for non-u.s. broker-dealers who may handle plan assets. Separately, the Pension Act includes an increase in the minimum bond amount from $500,000 to $1,000,000 for plans that hold employer securities, effective for plan years beginning after December 31,

13 9. 401(k) and IRA Investment Advice Exemption Background ERISA prohibits an investment manager from providing investment advice for a fee with respect to plan assets where investment choices resulting from the advice might generate additional fees or commissions for the manager or its affiliates. In fact, ERISA arguably prohibits a manager from providing advice for no added charge, if the advice could lead to investments that would generate different fees or commissions for the manager or its affiliates. To date, plan record keepers, mutual fund firms and other service providers to 401(k) plans and IRAs have avoided this trap by a variety of means sanctioned by the DOL, such as providing investment education, rather than advice, or by providing third-party investment modeling tools to plan participants and IRA holders. But a number of constituencies have been pushing for broader latitude to provide 401(k) participants and IRA holders with flexible, low-cost investment allocation guidance without having to worry, for example, whether the third-party allocation model they provide is sufficiently independent. New Investment Advice Exemption The Pension Act includes an exemption from the prohibited transaction rules of ERISA and the IRC for the provision of asset allocation advice to participants in participant-directed individual account plans (e.g., 401(k) plans), IRAs and similar tax-qualified accounts. The advice may be provided by a fiduciary adviser for a fee, even where the fiduciary or its affiliates stand to receive additional fees and commissions from the investments chosen by the participant or IRA holder, provided that either: (1) the advice is based on an objective computerized asset allocation model or (2) the fees and commissions received by the adviser and its affiliates will not vary based on the participant s investment decisions. This exemption for so-called eligible investment advice arrangements is effective for advice provided to a plan participant after December 31, 2006 and is subject to a number of checks and balances (described below). Model-Driven Allocation Advice With respect to model-driven allocation services, the exemption provides that a plan fiduciary may appoint a fiduciary adviser to provide advice to plan participants for a fee regarding the allocation of the participant s plan account among the investment options offered under the plan, provided that the participant makes the ultimate investment choices and the advice provided is based solely on a computer-based investment model that is certified as objective and unbiased by an eligible investment expert initially and after any material change to the model and the program is audited annually (with an audit report) by an independent auditor. The plan fiduciary must be independent of the fiduciary adviser and any other person providing investment options under the plan. The fiduciary adviser must be a registered investment adviser, a bank, an insurance company, a registered broker-dealer or any affiliate of the foregoing, and must acknowledge in writing that it is a fiduciary to each plan it serves. A computer-based investment model is a software program that applies generally accepted investment theories, considering historic returns of asset classes over a defined period of time and utilizing relevant data concerning the participant (e.g., age, life 13

14 expectancy, retirement age, risk tolerance, assets, and personal preferences for certain investments). The model may be designed and maintained by an independent third party or directly by the fiduciary adviser, provided that the model must cover all available investment options offered under a plan. If the model is provided by an independent third party, that party will also be considered a fiduciary to the plan accounts that utilize the model (although the DOL is empowered to adopt regulations providing conditions under which only the fiduciary adviser or the model provider would be viewed as a fiduciary, not both). An eligible investment expert qualified to certify the independence and merits of the investment model is a person who meets any requirements that the DOL may establish and bears no material affiliation or contractual relationship with any investment adviser or party related to any investment adviser. An independent auditor is a party who has appropriate technical training or experience and proficiency and so represents in writing and is not related to the fiduciary adviser or any other party providing investment options under the plan. The exemption also requires full disclosure to participants and account holders of the affiliations between the fiduciary adviser and the available investments, as well as a detailed summary of the fees, commissions and other compensation which the adviser and its affiliates stand to receive. As noted, the investment advice exemption is effective for advice provided to a plan participant after December 31, However, the Pension Act provides a delayed phase-in for modeldriven advice offered to traditional IRAs, education IRAs, qualified health and medical savings accounts and similar arrangements. The Pension Act directs the DOL to deliver a study to Congress by the end of 2007 analyzing whether appropriate models exist for these accounts, given that these accounts generally have a much broader array of available investment options than employer-sponsored plans, and the appropriate investment objectives and time horizons of certain of these accounts (e.g., health and medical savings accounts) may be more difficult to estimate. The relief for model-driven advice to IRAs and similar accounts will apply only after the DOL has completed its study and the relief is declared to cover these accounts. The Pension Act provides that if the DOL study is not able to endorse extending the new exemption to IRAs and similar accounts, the DOL must adopt a class exemption providing similar relief, subject to any additional conditions that may be appropriate for these accounts. Level Fee Arrangements As noted, in addition to exempting model-driven allocation arrangements, the new provisions exempt allocation advice arrangements in which the advisory fee and the fees and commissions earned by the adviser and its affiliates from the investments made by the participant or account holder do not vary as a result of the investment decisions of the participant or account holder. Level fee arrangements of this type are subject to almost all of the same requirements as model-driven arrangements, which may come as a surprise to those who would argue that an exemption is not even necessary for level fee types of arrangements. Whether the new exemption is intended to be the exclusive means for offering level fee arrangements is not entirely clear, but it is likely that the model-driven approach will be viewed as preferable by both providers and participants, at least in the case of most 401(k) plans. 14

15 If you have any questions regarding this memorandum, please contact Edmond T. FitzGerald at (212) , Erin K. Cho at (212) or any member of the Employment Practice Group Davis Polk & Wardwell 15