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August 21, 2006 01:00 AM

Pension reform loosens the reins on transactions

Doug Halonen
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    A small provision in the huge new pension reform law will make it much easier for financial institutions to conduct certain transactions with pension funds.

    The changes represents the biggest rewrite of the pension law's restrictive prohibited transactions rules since the Employee Retirement Income Security Act was signed into law nearly 32 years ago.

    Until now, financial service firms could only legally conduct transactions in which they were considered parties in interest if they demonstrated the transaction jibed with one or more of a series of prohibited-transaction exemptions carved out by lawmakers and the Department of Labor over the years, or if they sought an individual exemption, which could be costly and time-consuming.

    Under the new law, effective immediately, any transactions between a service provider to the plan and the plan will be permitted if the service provider is not a fiduciary to the assets involved in the transaction itself and the plan receives "adequate consideration" for the deal.

    (Click here for the complete legislation and links to key sections.)

    Adequate consideration, according to ERISA attorneys, means the transaction must be priced at the same value available in a publicly traded market, taking into account the size and liquidity of the trade. For deals that aren't traded in a market, a fiduciary would make a good-faith judgment of a transaction's fair-market value under regulations the Labor Department is supposed to generate.

    ‘On par'

    "This exemption puts pension plans on par with other investors today," said Elizabeth Varley, vice president and director of retirement policy for the Securities Industry Association, Washington.

    "Pension plans will now have freer access to capital markets," added Andrew Oringer, an attorney with Clifford Chance US LLP, New York, who specializes in matters relating to the Employee Retirement Income Security Act.

    Another widely publicized provision in the prohibited transaction rules would permit financial services firms to offer investment advice to defined contribution plan participants. But several other provisions in the new law — signed by President Bush on Aug. 17 — will make life easier for managers engaging in:

    • cross trading and block trading;

    • hedge fund access to pension funds;

    • electronic communication networks; and

    • foreign exchange transactions.

    Among the more common class exemptions were those involving standard securities transactions and securities lending.

    Newer types of transactions, involving some forms of derivatives, didn't fit neatly into existing exemptions. So attorneys have run up substantial fees over the years trying to shoehorn deals into existing class exemptions, a process that delayed even those deals that ultimately could be justified. And some transactions — including foreign securities lending — couldn't be done without first getting an individual exemption from the Labor Department.

    Other kinds of deals, including swap transactions, could only be done if conducted through an independent qualified professional asset manager or an in-house asset manager, firms registered with the Securities and Exchange Commission that meet other stringent conditions established by the Labor Department.

    "There will be less nit-picking at numerous conditions on exemptions, and the focus will be where it should be: whether the plan is getting adequate consideration," said A. Richard "Brick" Susko, an ERISA attorney with Cleary Gottlieb Steen & Hamilton LLP, New York.

    Said David Abbey, vice president and associate counsel with T. Rowe Price Group Inc., Baltimore: "It makes it easier to do the transaction because all you have to worry about is whether it's an arm's-length transaction where the plan is not paying more than it should be paying."

    Here are details on some of the new provisions.

    The prohibition on cross trades between at least one pension fund and another client managed by the same manager have been relaxed significantly. Under the old law, cross trades were generally only permissible for purely quantitative strategies and index funds. Under the new law, the manager may conduct active cross trades if the plan has more than $100 million in assets, the transaction was conducted at the current market price of the security, and no commission or brokerage fee was charged.

    Chris Wloszczyna, a spokesman for the mutual fund industry's Investment Company Institute, Washington, said the $100 million threshold would limit the cross trades to 3.9% of the nation's defined benefit plans.

    Said David Tittsworth, executive director of the Investment Adviser Association, Washington: "This is a very finely negotiated provision that will have limited applicability, but it's at least a step in the right direction."

    The new law also eases restrictions to allow block trading — transactions allocated across two or more unrelated client accounts of a plan fiduciary — if the trade is for at least 10,000 shares or has a market value of at least $200,000, and the pension plan doesn't own more than 10% of the shares traded. In addition, the terms of the deal are supposed to be at least as favorable to the plan as an arm's-length transaction.

    Under the new law, hedge funds and private equity firms will have a much higher threshold before being considered fiduciaries.

    Before, hedge and private equity funds with more than 25% of their assets from public, private and foreign employee benefit plans were considered fiduciaries under ERISA. Now, only U.S private employee benefit plans count toward the 25% threshold. Being considered a fiduciary exposed hedge fund managers to potential liabilities if any of their investments went sour.

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