U.S. Labor Department Makes Changes in Prohibited Transaction Class Exemptions - Reduced Transaction Costs and Increased Opportunities for Plans and Financial Services Firms May Result

Over the past three months the U.S. Department of Labor ("DOL") recently released one new class exemption, three proposed amendments to existing class exemptions and one proposed amendment to a widely applicable series of individual amendments. These new exemptions or amendments liberalize application of the ERISA and Internal Revenue Code prohibited transaction rules to plans, plan fiduciaries and the financial services and other institutions that serve plans. The class exemption and proposed amendments (which are likely to be adopted substantially as proposed) permit fiduciaries to engage in limited "passive" cross-trading, permit trustees with discretion over plan assets to use affiliated broker-dealers to effect securities trades for plans, permit plans to sell a life insurance policy to a personal trust established by a participant, and expand the existing fast-track exemption procedure. Two of the new exemptions or amendments (cross trading and trustee use of affiliated brokers) are available only to large plans (defined generally as plans with more than $50 million in assets) and financial services institutions serving such plans. The prohibited transaction rules have come under increasing criticism from employers, financial institutions and other service providers as unreasonably restrictive of transactions that are favorable to plans. The class exemption and proposed amendments represent the DOL’s attempt to use the administrative exemption process to permit some of the transactions sought by plan sponsors and the financial services industry. Sponsors and financial services firms may decide that the DOL has only partially succeeded. Each new class exemption or proposed amendment is discussed below.

This class exemption permits passive cross-trading between a plan or an account that holds plan assets and an "index or model driven fund" or two "large accounts" in connection with a portfolio restructuring as long as certain conditions are met. Many plan sponsors, fiduciaries and investment professionals have complained that ERISA’s prohibited transaction rules and current statutory and administrative exemptions wrongly forbid cross-trades, i.e., trades between a plan (or an account holding plan assets) and another account managed by the same manager. Many financial professionals favor cross-trading as a favorable way to minimize transaction costs when buying or selling securities.

In general, SEC rules permit investment advisors to cross-trade publicly traded securities for their non-ERISA accounts as long as the practice is disclosed and client consent is obtained. The DOL, however, has long held that cross-trading by a fiduciary who has discretion to trade for both accounts is a per se prohibited transaction and impermissibly places the plans at risk. The DOL has specifically rejected arguments that disclosure and consent along the lines approved by the SEC is adequate to protect plans. However, the DOL has permitted "agency" cross-trades (where an investment manager has discretion only with respect to one side of the transaction) in PTCE 86-128 and issued a number of individual prohibited transaction exemptions permitting other cross-trades under limited circumstances.

PTCE 2002-12 approval of passive cross-trades arguably represents a change in the DOL’s position on cross-trading. However, the change is limited for the exemption permits cross-trading only under conditions that effectively limit or remove much of the discretion involved in the decision to cross-trade. In general, the exemption permits cross-trades of widely held equity and fixed income securities at closing prices where the cross trade is between two "index funds" or "model driven funds"; one such fund and a "large account" or between two "large accounts" pursuant to a "portfolio restructuring program." Cross trades are permitted only within three days after the occurrence of a "triggering event."¹ Cross trade opportunities must be fairly allocated among accounts and the manager cannot receive any fee for cross trades. In house managers are largely prohibited from using the exemption. A fiduciary independent of the manager must provide advance approval of participation in the cross trading program and must be offered detailed information about the program. The independent fiduciary must receive annual information about the program and must be allowed to withdraw from the program on short notice. Large accounts that participate in a portfolio restructuring program must receive a written record of all cross trades involved in the program. It appears that the DOL would permit required information to be included in the manager’s Form ADV.

Because many large plans rely heavily on indexed funds and other passively managed strategies for their publicly traded U.S. equity and fixed income investments, PTCE 2002-12 has the potential to become very useful and may ultimately lead to significant savings of trading expenses for such plans. However, investment managers and fiduciaries may ultimately decide that the exemption’s conditions are too onerous and make the exemption unworkable.

The Underwriters Exemptions are a series of individual exemptions that permit plans to purchase mortgage backed or certain other asset backed securities. Interests in pooled mortgage trusts or other asset backed pooled trusts may be attractive investments for plans but may constitute prohibited transactions if a party in interest with respect to the plan is the trustee of the pooled trust or a member of the underwriting syndicate. In order to permit plans to take advantage of potentially favorable investment opportunities in such pooled trusts but protect plans against potential abuses that may exist, the DOL issued a number of individual exemptions to underwriters of such securities, known as the "Underwriter Exemptions."

Currently, the Underwriter Exemptions do not permit the trustee of the pooled trust to be an affiliate of a member of the pooled trust’s "restricted group," which includes, in addition to the trustee, the underwriters, servicers, insurers, sponsors, counterparties in certain swap agreements, five percent or more obligors of receivables in the pooled trust, and affiliates of these persons. Bank mergers and other consolidation of financial services firms have made this restriction increasingly unworkable and the proposed amendment would permit the trustee to be an affiliate of another member of the restricted group. The proposed amendment also acknowledges that trustees of such pooled trusts have very little discretion with respect to trust operation and that this significantly reduces the risk of abusive conduct that would harm plan investors. The proposed amendment will make it easier for plans to invest in mortgage and other asset-backed pooled trusts and will reduce the need for plans to sell such assets as a result of an unrelated bank or financial services merger.

PTCE 86-128 permits most fiduciaries to effect securities transactions using an affiliated broker dealer under certain conditions. However, the exemption is not available to a trustee with any discretion over plan assets. Such trustees must now use an unaffiliated broker dealer to execute transactions. The proposed amendment would permit trustees of large plans (defined as $50 million in net assets, $50 million in net assets for a group of plans in a single master trust, or, in the case of pooled trusts, 50 percent of trust units held by plans with at least $50 million in net assets) to use the exemption to execute securities transactions as long as the trustee provides at least annual disclosure of total brokerage commissions (in dollars and cents per share) paid by the plan to affiliated brokers and unaffiliated brokers.

Industry groups initially sought this relief when the exemption was first issued in 1986 but the DOL rejected the request. The DOL changed its position in light of ongoing consolidation in the financial services industry, the higher costs plans may pay when a trustee is forced to use an unaffiliated broker and the sophistication that the DOL assumes that fiduciaries of large plans have and their concomitant ability to monitor and the use of affiliated broker dealers.

PTCE 96-2 permits a plan to sell individual life insurance policies (for cash surrender value) to participants insured under a policy, relatives of such participants, employers of such participants or another employee benefit plan under certain conditions. Some pension plans use life insurance policies on the lives of participants to funds retirement benefits and to provide a pre-retirement death benefit, which commonly ceases on the participant’s retirement. Such plans may offer the participant the opportunity to purchase the life insurance at retirement for cash value. Such sales are permitted only if the terms of the PTCE are met, which currently precludes sales to personal trusts, defined as trusts established by participants or for the benefits of their relatives. Personal trusts are, of course, commonly used to reduce estate taxes. The DOL proposed amendment will permit a plan to sell policies to personal trusts, which may assist participants in structuring their estate plans. If the amendment is adopted, PTCE 92-6 will permit sales to personal trusts effective February 12, 1992.

PTCE 96-62 establishes a "fast track" prohibited transaction exemption application process. An applicant can engage in an otherwise prohibited transaction if it demonstrates that the proposed transaction is substantially similar (in the DOL’s view) to two transactions that the DOL has previously approved within 60 months of the date the application was filed. Applicants file an abbreviated application for an exemption that takes effect unless the DOL decides the exemption should not be granted. This fast-track process has been fairly successful, with over 160 applications granted since it was initially adopted, many of which involve sales of assets between plans and parties in interest.

Among other reasons for the initial exemption, the DOL sought to reduce the time and resources needed to apply for, process, and approve exemptions that it viewed as routine. However, because applicants may not use transactions approved under PTCE 96-62, the exemption in its current form ensures that there will be an ever-shrinking pool of PTEs to use as models for a fast-track application. To alleviate this problem, the DOL proposes to amend PTCE 96-62 to permit applicants to use two individual exemptions approved within the past 120 months or one exemption approved in the past 120 months and one exemption approved under PTCE 96-62 within the past 60 months. The amendment will create a larger pool of prohibited transaction exemptions to use in applying for a "fast track" exemption, ensuring the continuing usefulness of PTCE 96-62.