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News September 25, 2006 Issue

Industry Groups Lobby for Broader ERISA Cross-Trade Relief

The cost of a nice bottle of champagne to celebrate the new active cross-trade relief in the Pension Protection Act?

$150.

The threshold that an ERISA plan must meet before an adviser can rely on that new relief?

$100 million.

Eliminating that threshold?

Priceless.

The ink is barely dry on the Pension Protection Act, but that didnít stop a group of industry representatives from asking DOL last week to administratively reduce or eliminate the $100 million threshold in the Actís active cross-trade provision.

On September 20, a panel of industry witnesses testified before the "Working Group on Plan Asset Rules, Exemptions, and Cross-Trading of [DOLís] Advisory Council on Employee Welfare and Pension Benefit Plans." The subject: the new statutory cross-trade exemption for actively-managed ERISA accounts. While the panelists praised the exemption, they argued that the $100 million plan asset threshold was unnecessary and in fact disadvantaged smaller plans not able to rely on the exemption.

Henry Hopkins, chief counsel of T. Rowe Price Group, testified on behalf of his firm as well as on behalf of the Investment Adviser Association and the Investment Company Institute. He began by emphasizing the cost savings associated with cross trades. Commissions and mark-ups for trades conducted on the open market, he said, typically range from $.03 to .06 per share. That, he noted, scales up to $60 to $120 for a transaction involving 1,000 shares of stock. "Over the course of a year, these accumulated commissions can represent a significant cost to a retirement plan," he said. In contrast, cross-trades made pursuant to the new statutory exemption, which is modeled on ICA Rule 17a-7, may not involve a commission, mark-up, or other remuneration.

Hopkins also pointed to cost savings claimed by firms that have obtained individual cross-trade relief, such as Barclays Global Investors, State Street Bank and Trust, and Morgan Stanley Asset Management, which have reported cost savings in the range of $300 million per year. Congress "implicitly recognized" such cost savings when it enacted the Pension Protection Act, he said.

With that, Hopkins praised Congressí enactment of the exemption, particularly its decision to base the exemption on ICA Rule 17a-7. That rule, he said, has proven effective for over 40 years, and using it as a framework promotes regulatory consistency.

Hopkins then urged DOL to coordinate with the SEC when developing rules for the cross-trade policies and procedures required by the new statutory exemption. "Clearly," he said, "the intent of Congress is for [DOL] to work with the SEC in crafting the requirements for such policies and procedures in a manner [that] ensures that they are consistent with SEC Rule 17a-7."

Hopkinsí main focus, however, was on the exemptionís dollar threshold, which limits the availability of the cross-trade exemption to pension plans with at least $100 million in assets. "While we appreciate and agree with Congressí desire to ensure that plan fiduciaries have the level of sophistication necessary to monitor the cross-trade transactions executed on behalf of their plan," said Hopkins, "a $100 million threshold prevents all but the largest 3.9 percent of defined benefit plans from being able to benefit from the ability to increase incremental returns on their capital through cross-trading programs."

In Hopkinsí view, the $100 million threshold is "unnecessary." If, however, regulators seek to maintain some form of sophistication test, Hopkins suggested two alternatives. First, the cross-trade exemption could be made available to pooled funds, such as common trust funds, where at least one plan investing in the pool has total assets of over a certain threshold, say, $100 million in total assets. "This condition would ensure that at least one plan participating in a pooled fund with a cross-trade program would be considered to have sufficient financial expertise to evaluate the periodic reports that the investment manager is required to provide pursuant to the Act."

Second, Hopkins suggested that plans that retain "sophisticated consultants" be allowed to rely on the exemption. A "bright-line test" such as a $100 million threshold "fails to recognize that plan sponsors may also have other resources available to assist them in fulfilling their duties," he said. "[S]o long as a planís participation in a cross-trade program is reviewed by a party who is unrelated to the investment manager engaging in the cross trade, and who is considered to have the necessary sophistication to properly evaluate the planís participation in a cross-trade program, the plan should not be precluded from the opportunity to increase its incremental returns on its capital through participation in a cross-trading program that otherwise meets the requirements of the Act."

Mary McDermott-Holland, head of equity trading at Franklin Portfolio Associates, testified that her firm has determined that "several" of its ERISA accounts would not be able to take advantage of the new relief, because they do not meet the $100 million threshold.

She urged DOL to propose an exemption for smaller plans. "A cross trade is not just a low or no commission trade, but a zero market impact/zero opportunity cost transaction," she said. "The ability to cross trade is a valuable tool for the trader in satisfying the best execution obligations [with respect to] two clients on separate sides of the same stock." Small plans, she said, "should not be penalized based on their size and furthermore need the cost savings just as much, if not more than the large plans."

McDermott-Holland noted that regulatory and procedural safeguards, such as examinations and the requirements to obtain client consent and provide clients with trading information, guard against abusive cross trades. She also predicted that the market would discipline firms that engaged in abusive crosses. "The investment management market is highly competitive," she said. "An investment manager that is not trustworthy and/or does not provide good investment performance or client service will lose business."

Scott Lopez, director of global equity trading at Wellington Management Company, emphasized that portfolio management and trading are separate functions within the asset management process. "The investment decision is independent from the choice of trading venue," he said.

Lopez acknowledged that "skeptics" may question how a firm can have internal cross-trading opportunities, but explained that accounts with different investment styles and different cash situations can legitimately present such opportunities. "While a stock may no longer be appropriate for a small-cap portfolio because its market value has grown too large, that same security may now be attractive to a mid-cap portfolio," he noted. "Further still, a redemption by one client could occur at the same time, or nearly the same time, as a cash inflow by another client."

Lopez pointed to the trading volumes of crossing networks, such as Instinet, Liquidnet, and Pipeline, as evidence "that there is a clear appetite to avoid market impact costs." He acknowledged concerns about "dumping," which led to the $100 million sophistication test in the statute. However, he argued that any correlation between a planís size and its sophistication is "tenuous as best." Restricting cross trading would not prevent improper portfolio management decisions, he said. Instead, it would only serve to deprive smaller plans "of an important and highly-beneficial trading venue."

Kirkpatrick and Lockhart partner William Schmidt testified in his personal capacity as an ERISA lawyer. "The cross-trade exemption in the Pension Protection Act does not have to be the end of the story," he said. In his view, nothing in the Act prohibits DOL from re-examining the $100 million threshold. He emphasized that the benefits of cross-trade relief flow to plans and plan participants, not investment managers.

And, he added, monitoring cross trades "is not rocket science." With appropriate reporting, he said, "most diligent fiduciaries should be able to detect and inquire about any indications of abuse."