“Extra-Extra!!! Wall Street Reform Harms ERISA Plans!”

Posted on 12/08/2010

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The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) was passed to “promote the financial stability of the United States” and to protect consumers from “abusive financial services practices.”[1] It will bring unprecedented change to the securities and derivative investments markets.  It will also negatively impact participants of employee benefit plans subject to the Employee Retirement Income Security act of 1974 (“ERISA”).

ERISA plans hold swaps[2] and other derivatives to hedge against market risks.  These positions also benefit plan sponsors insofar as they reduce volatility and make funding obligations more predictable.  Dodd-Frank authorizes regulation of the swap and security-based swap markets.[3] The Act also mandates unnecessary and counterproductive treatment for ERISA plan investors.

I. Calling ERISA Plans “Special”

Title VII of the Dodd-Frank Act is known as the Wall Street Transparency and Accountability Act of 2010 (“WSTAA”).  Section 731 of WSTAA introduces new standards of business conduct for certain swap counterparties (i.e.: “swap dealers” and “major swap participants” (“MSPs”)).[4] WSTAA also singles out various other counterparties and labels them “Special Entities.”[5]

ERISA plans are classified as Special Entities, and swap dealers and MSPs transacting with them must adhere to an additional set of standards enumerated under §731(h)(5).[6] Specifically, §731(h)(5)(A)(i) requires a swap dealer or MSP that offers to enter into a swap with a Special Entity to have a reasonable basis to believe that the Special Entity has an independent representative that—

“(I) has sufficient knowledge to evaluate the transaction and risks;

(II) is not subject to a statutory disqualification;

(III) is independent of the swap dealer or major swap participant;

(IV) undertakes a duty to act in the best interests of the counterparty it represents;

(V) makes appropriate disclosures;

(VI) will provide written representations to the Special Entity regarding fair pricing and the appropriateness of the transaction; and

(VII) in the case of employee benefit plans subject to the Employee Retirement Income Security act of 1974, is a fiduciary as defined in section 3 of that Act[.]”[7]

Section 731(h)(5)(A) is problematic for several reasons.  The following discussion examines why its structure will misinform counterparties about ERISA and create ineffective busy work.  The over-arching problem, however, is the potential for this “special” treatment to discourage swap transactions with ERISA plan investors altogether.

II. Questioning the Fiduciary’s Independence

As an initial matter, §731(h)(5)(A)(i) calls for the Special Entity to have an “independent representative.”[8] Later, element (III) specifically calls for independence from the swap dealer or MSP.[9] Legislative history clarifies that §731(h)(5)(A)(i) does not require the representative to be independent of the Special Entity, but rather be independent of the swap dealer or MSP.[10] Therefore, §731(h)(5)(A)(i) and element (III) are saying the same thing twice.

The result is not merely surplus verbiage; it creates misunderstanding and is in tension with Dodd-Frank’s legislative intent.  Indeed, a natural reading of these provisions appears to call for an “independent” representative who is also independent of the swap dealer or MSP.  It strains the imagination to believe both clauses describe the same requirement.

Later, element (VII) also becomes infected by this tension.  As already discussed, element (III) calls for independence of the swap dealer or MSP.  This implies §731(h)(5)(A)(i) requires a different sort of independence.  Furthermore, §731(h)(5)(A)(i) calls for an “independent representative” that element (VII) requires be “an ERISA fiduciary.”[11] Thus, when §731(h)(5)(A)(i) and element (VII) are read together, we are led again to the erroneous belief that the fiduciary must be independent of the Special Entity.  After all, if there are only two parties to a swap, and element (III) requires independence of the swap dealer or MSP, who is left?

Furthermore, elements (III) and (VII) are to be read in conjunction with each other – due to the appearance of the word “and” following element (VI).  Thus, the rule demands the ERISA fiduciary be independent of the swap dealer or MSP.  The implication shed by this requirement is absurd.  ERISA prohibits its fiduciaries from representing any party whose interests are adverse to the plan.[12] Causing a plan to enter into a swap transaction with counterparties to whom the fiduciary is affiliated is therefore disallowed under ERISA.

While the independence requirement of §731(h)(5)(A)(i) is clearly aimed at ferreting out conflicts, it sadly creates some of its own.  The two references to independence are duplicative and create confusion.  Furthermore, pairing them with element (VII)’s fiduciary requirement misinforms the public and falsely implies the ERISA law needs such protection.

III. Underestimating the Fiduciary

Adding insult to injury, the remaining elements under §731(h)(5)(A) merely spread more confusion about ERISA.  In fact, each continues to misinform the reader about ERISA while also failing to add any new protection.  This is because element (VII) calls for an ERISA fiduciary, and ERISA’s standards of conduct for plan fiduciaries already incorporate each of the safeguards found in elements (I) through (VI).

Element (I) requires the representative to have sufficient knowledge to evaluate the transaction and its risks.[13] Nevertheless, ERISA’s fiduciary duties have provided this protection since that law’s inception.  Indeed, an ERISA fiduciary lacking requisite knowledge is obliged to obtain it.[14] Only then will he be discharging his duties with the same care, skill, and diligence as a prudent man familiar with such matters.[15]

Element (II) prevents transactions with representatives subject to statutory disqualification.[16] The circumstances giving rise to such disqualification boil down to the commission of felonies and willful violations of securities or commodities laws.[17] ERISA prohibits persons from serving as fiduciaries if they have been convicted of, among other things, a felony or any crime described in §9(a)(1) of the Investment Company Act of 1940.[18] Section 9(a)(1) proscribes felonies and misdemeanors involving the purchase or sale of any security.[19] Thus, element (II)’s safeguard is one firmly built into ERISA.

Element (III) calls for independence from the swap dealer and MSP.[20] As previously discussed[21], element (III) is unnecessary given ERISA’s prohibition of self-interested acts by a fiduciary, and of a fiduciary’s representation of those with interests adverse to the plan.[22]

Element (IV) requires the representative act in the Special Entity’s best interest.[23] An ERISA fiduciary must act with an “eye single” to the interests of the plan’s participants and beneficiaries.[24] The ERISA duty of prudence requires diversification of the plan’s investments, adherence to the documents and instruments governing the plan, and ongoing attention to the plan’s conformity with the law.[25] Moreover, an ERISA fiduciary is prohibited from dealing with plan assets in his own interest[26], and will be held personally liable for any breach of his duties.[27] It is therefore an understatement that an ERISA fiduciary must act in the plan’s best interest.

Element (V) requires the representative make appropriate disclosures to the ERISA plan investor.[28] ERISA is steeped in trust law, and transparency is a theme found throughout its statutory provisions and regulatory scheme.  As such, ERISA fiduciaries are obligated “to convey complete and accurate information material to the beneficiary’s circumstance, even when a beneficiary has not specifically asked for the information.”[29]

Element (VI) requires written representations be made regarding the transaction’s fair pricing and appropriateness.[30] An ERISA fiduciary has a duty to defray reasonable expenses and act with the same diligence as one familiar with such matters.[31] Representations as to an investment’s price and fees would be relevant to the defrayment of plan expenses.  Moreover, consideration of an investment’s appropriateness with respect to the plan’s needs is mandatory, lest the fiduciary fail to exercise his duties diligently and in accordance with the documents and instruments governing the plan.[32]

WSTAA presents a danger to employee benefit plans by misinforming the public about ERISA’s built-in protections.  When it comes to ERISA plans, elements (I) through (VI) are wholly unnecessary and serve only to confuse.  The culprit is the conjunctive “and” following element (VI).[33] It binds the first six elements to the seventh, and creates a meaningless laundry-list for compliance that is certain to discourage counterparties from transacting with ERISA plans.

IV.       Well this is a Fine Mess…

Even if the spirit of WSTAA’s 731(h)(5) protections should carry the day, the language is complicated and warps the public’s view of ERISA.  It could also result in restricted swap market access for ERISA plans.  Thus, in its zeal to serve the public interest, Dodd-Frank ends up harming a “Special Entity” it sought to protect.

Nevertheless, the timeliness of this circumstance is ironic.  In fact, ERISA fiduciaries do need help, but they need education more than special treatment.  Like many of us, plan fiduciaries often fail to recognize the different standards of care owed them by various financial agents.  Indeed, fiduciaries are often confused over who does or does not share in their ERISA liability.

To financial service providers, however, ERISA plan clients represent a heightened degree of liability, and providers typically do not wish to incur the additional risk.  Financial advisers prefer to remain liable only to the extent prescribed by the Investment Advisers Act of 1940, which requires them to act in the client’s “best interest.”  Brokers, dealers, and insurance agents owe an even lesser duty; they need only consider an investment’s “suitability” with respect to the client’s portfolio.

This leaves ERISA fiduciaries in a perilous position.  After all, ERISA plan fiduciaries need expert advice, and they usually follow the advice they purchase.  Nevertheless, while the expert is the one producing the advice, the ERISA fiduciary remains solely liable for having followed it.  Perhaps a little lip service from Dodd-Frank is therefore in order.  Perhaps unsophisticated actors in the market ought to be protected by a higher degree of care.

Such consideration would not be unique: Another of Dodd-Frank’s mandates directs the SEC to consider raising the “suitability” standard of care owed by brokers and dealers closer to the “best interest” level followed by investment advisers;[34] the Department of Labor (“DOL”) recently proposed a new regulation defining an ERISA §3 fiduciary in order to bring more financial actors within its purview;[35] and the Office of Inspector General just released an audit of the DOL’s Employee Benefit Security Administration (“EBSA”) entitled “EBSA Needs To Do More To Protect Retirement Plan Assets From Conflicts Of Interest.”[36]

V.        Opportunity is Knocking!

Some might say a swap party should only have to concern itself with whether the other is eligible to contract.  In the spirit of Dodd-Frank’s policy to protect, however, it seems fair that an initiating swap party ought to be cognizant of any unique vulnerabilities of the other.  In fact, fiduciaries could use a gentle reminder of their predicament, as well as the value of employing experts who are willing to share in ERISA liability.

To this end, element (VII) could serve as such a reminder.  However, the thicket of prongs (I) through (VI) must be untangled from the one that actually does some good.  The change can be affected by replacing the conjunctive “and” following element (VI) with the word “or.”  The law would then simply require an initiating swap dealer or MSP to have a reasonable basis to believe that the ERISA plan counterparty is represented by an ERISA fiduciary.  Of course, not much will remain of the rule, but not much was there in the first place.[37]

This unfortunate result of Dodd-Frank’s effort to overprotect ERISA plan investors now presents the field with a unique opportunity to educate.  Changing “and” to “or” will clarify §731(h)(5)(A)’s usefulness as a conversation starter.  The remaining rule will ask a simple question: “Does the ERISA plan with whom you seek to contract have a fiduciary?”  Initiating counterparties would then have to ask the ERISA representative: “Are you an ERISA fiduciary?”  And this, in turn, might encourage ERISA fiduciaries to ask their experts a very important question: “Are you my fiduciary?”


[1] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub L. No. 111-203, available at: http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf.
[2] “Swaps” and “security-based-swaps” may be loosely defined as “any put, call, straddle, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of one or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind […] or in the future becomes, commonly known to the trade as [such.]”  See Dodd-Frank §§ 711 and 721(b).
[3] See Dodd-Frank Act, Title VII – Wall Street Transparency and Accountability Act of 2010 (“WSTAA”), Subtitle A, amending sections 4 of the Commodity Exchange Act (CEA) and 15 of the Securities Exchange Act (SEA), respectively.
[4] WSTAA §731 applies to swaps and §764 applies to security-based swaps.   The provisions are virtually identical and §731 will hereinafter serve in this article as a proxy for discussion of both.
[5] WSTAA §731(h)(2)(C).
[6] WSTAA §731(h)(2)(C)(iv).
[7] (Emphasis added), WSTAA §731(h)(5)(A)(i).
[8] Id.
[9] WSTAA §731(h)(5)(A)(i)(III).
[10] In a Senate Colloquy, Senator Blanche Lincoln of Arkansas posited “Our intention in imposing the independent representative requirement was to ensure that there was always someone independent of the swap dealer […] approving [… these] transactions.” 111 Cong. Rec. S5903 (2010).
[11] WSTAA §731(h)(5)(A)(i)(VII).
[12] ERISA §406(b)(2).
[13] WSTAA §731(h)(5)(A)(i)(I).
[14] DOL Reg. §2509.95-1(c)(6).
[15] ERISA §404(a)(1)(B).
[16] WSTAA §731(h)(5)(A)(i)(II).
[17] See SEA §§ 3(A)(39) and §15(B)(4).
[18] ERISA §411(a).
[19] See 15 U.S.C. 80a-9(a)(1).
[20] WSTAA §731(h)(5)(A)(i)(III).
[21] Supra this article: “II. Questioning the Fiduciary’s Independence”.
[22] ERISA §406(b)(2).
[23] WSTAA §731(h)(5)(A)(i)(IV).
[24] Donovan v. Bierwirth, 680 F.2d 263 (2d Cir. 1982).
[25] ERISA §404(a)(1)(C) and (D).
[26] ERISA §406(b)(1).
[27] ERISA §409(a).
[28] WSTAA §731(h)(5)(A)(i)(V).
[29] Barker v. American Mobil Power Corp., 64 F.3d 1397, 1403 (9th Cir. 1995).
[30] WSTAA §731(h)(5)(A)(i)(VI).
[31] ERISA §404(a)(1)(A)(ii) and (B).
[32] ERISA §404(a)(1)(B) and (D).
[33] WSTAA §731(h)(5)(A)(i)(VI).
[34] See See Dodd-Frank, Title IX, Subtitle A, §913.
[35] See Definition of the Term “Fiduciary,” 75 Fed. Reg. 65263 (Oct. 22, 2010).
[36] U.S. Department of Labor, Office of Inspector General, Office of Audit, Report Number: 09-10-001-12-121; available at: http://www.oig.dol.gov/public/reports/oa/2010/09-10-001-12-121.pdf.
[37] Significantly, WSTAA’s §731(h)(5)(A)(i) only requires the party initiating a swap with a  Special Entity to believe that the ERISA plan “has” a representative that element (VII) requires be an ERISA fiduciary.  Read literally, it appears the initiating party need not investigate whether the representative executing the swap on behalf of the ERISA plan is the fiduciary in question.  Thus, if the question presented is simply: “Does this ERISA plan have a fiduciary?”  Of course, the answer must be yes.  If an ERISA plan has no identifiable fiduciary, the DOL will consider it abandoned and likely seek its termination.  The belief requirement, therefore, is another of WSTAA’s rules already covered by ERISA.  Furthermore, even if the rule required the representative executing the swap to be the fiduciary in question, ERISA again provides the answer.   ERISA §405(c)(1) allows for the delegation of responsibilities among named fiduciaries, and for the retention of third-parties to carry out certain directions.  Moreover, persons exercising discretionary authority or control over the management or disposition of plan assets will be deemed fiduciaries under ERISA §3.  Thus, any person holding themselves out as a representative with authority to execute a swap on behalf of an ERISA plan will be either a named fiduciary, a third-party delegate, a fiduciary in fact, or an imposter!
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