Andrew L. Oringer is a partner and the senior member of the ERISA Department of Clifford Chance US LLP. He would like to thank Craig Spenner and Elana Krieger, associates in the ERISA Department, for their assistance with the preparation of this report.

On July 28, 2006, the House of Representatives passed H.R. 4, the Pension Protection Act of 2006.¹ H.R. 4 is now expected, as part of a complicated path to possible enactment, to be considered by the Senate and then (subject to possible changes by the Senate and another House-Senate conference, or deferral or rejection altogether) signed by the President. This report is now being included here in light of the wide-ranging potential impact of the provisions that have passed the House.

The pension reform provisions that have been most heavily covered in the press have been those relating to pension funding and certain investment-related matters. Also included in H.R. 4, however, are a number of provisions which, while essentially technical in nature, may have a dramatic effect on the manner in which ERISA’s fundamental fiduciary restrictions will operate. In particular, the basic prohibited transaction rules and the rules governing the determination of when assets are considered to be assets of an employee benefit plan subject to ERISA² have been adjusted and contoured. The changes can be critical, in light of the ways in which ERISA has come to apply in practice and the ever-growing extent to which global investment capital comes from employee benefit plans. Indeed, in this author’s view, the changes may well be among the more important fundamental changes to ERISA since its enactment in 1974 and to the plan asset rules since their issuance in 1986. This report relates only to the provisions of H.R. 4 that seem to have gotten relatively less coverage, and therefore does not address, for example, such items as the pension funding rules, rules governing automatic enrollment in “401(k)” plans and rules relating to investment advice under so-called “participant-directed” plans.

Prohibited Transactions.

In the case of the prohibited transaction rules, to address fiduciary misconduct, ERISA (including the corresponding provisions of the tax code) generally prohibits a wide range of transactions between a plan and a party in interest unless an exemption applies, regardless of the fairness or propriety of the transaction, and imposes excise taxes and other penalties on the party in interest involved in the transaction.³ Examples of parties in interest include employers, fiduciaries, participants, and applicable labor unions, and one can understand why transactions with such parties would be presumptively prohibited, regardless of their terms. However, when ERISA was initially passed, Congress in 1974 struck a balance under which mere service providers were also included within the scope of those parties in interest with which a plan cannot transact business absent an exemption. This inclusion was an expansion of the common law of trusts on which ERISA was in many respects modeled, and Congress seems to have felt was justified in light of the statute’s remedial purposes and the overall statutory scheme. Arguably, this expansion of the common law is responsible, more than any other aspect of ERISA, for an overbreadth in ERISA’s reach that has caused aspects of the market to view the statute as a counterintuitive impediment to a host of reasonable transactions.

In this author’s view, the laboratory of the marketplace, especially in light of the consolidation of the financial services industry, has revealed this choice to be overbroad as a practical matter. In effect, a prohibition on transactions just with insiders had become the general rule, as financial services organizations have come to assume that they might be or become service providers to any given plan and to plans generally, thus requiring the identification of an exemption for every transaction, rather than just for transactions with obvious insiders. Under the bill, in the case of a transaction between a plan and a mere service provider, the transaction generally would only be prohibited if the transaction is for other than adequate consideration.⁴ Although there are a number of questions regarding the determination of “adequate consideration” for these purposes, the new bill's modified approach, when taken in conjunction with changes that offer a correction period,⁵ may permit plans and financial services organizations to complete many transactions more freely, while still providing protection for plans and their participants and beneficiaries.

Plan Assets.

The plan asset rules presented a somewhat different challenge. The Department of Labor has long (since at least Interpretive Bulletin 75-2⁶ in 1975) wrestled with the deceivingly difficult question of when an asset should be considered to be owned by an ERISA plan that has an indirect ownership interest in the asset, and therefore should be covered by the fiduciary protections provided by ERISA. Those rules, manifested in so-called “legislative” regulations,⁷ included a 25 percent test under which the Department of Labor generally sought to identify those entities being marketed to fiduciary-type entities. In general, if less than 25 percent of each class of equity-type interest of an entity is owned by benefit plan investors (whether or not subject to ERISA), the entity’s assets (as distinguished from the interests in the entity) are not considered plan asset covered by ERISA.⁸ As the test was not fashioned as a de mimimis test, but rather sought to identify situations in which there may be a substantial expectation that the entity’s assets would be managed in furtherance of the investment objectives of plan investors,⁹ it was drafted to take into account not only ERISA plans but also non-ERISA plans, including governmental and non-US plans. While there was a stated principled justification to this approach, the effect has been to cause monitoring difficulties, an adverse effect on the ability of sponsors of investment opportunities efficiently to attract capital and other basic confusion in the market. The 25 percent test, as modified by the bill,¹⁰ generally looks only to investment by ERISA plans to determine which plans count as plan investors for purposes of the test.

An example of monitoring issues under the 25 percent test as previously in effect includes problems in markets (including especially many non-US markets) which are often paperless, which can be exacerbated by a lack of understanding (or indifference) on the part of investors not subject to ERISA regarding a set of complex regulatory rules which do not even directly apply to the non-ERISA investor being asked to provide (and often certify to) information regarding plan or non-plan status. More basically, confusion and consternation may arise, for example, as some in the market would question how it could be that a non-ERISA plan could be subject to the ERISA regime at all, where, by hypothesis, the ERISA regime is inapplicable to non-ERISA plans. (The subtle answer is that ERISA doesn’t apply to the non-ERISA plan; rather, the 25 percent test, where ERISA may apply (i.e., where there is any equity investment from ERISA plans), counts the non-ERISA plans.)

Compounding the problem was that a wide variety of approaches and variation in the market (depending on, among other things, which advisors were on any particular transaction) had developed regarding the nature of compliance-related steps that would result in an adequate comfort level regarding satisfaction of the 25 percent test, as well as regarding the interpretation of the meaning and effect of the provisions of the rule itself. The rule, which was seemingly designed to be a bright-line path to addressing ERISA compliance, has become a source of practical and interpretive questions that ultimately proliferated in business and legal circles. The adverse effects have included an extra-territorial disruption of international capital markets. There has also been a constricting effect on investment opportunities for the very ERISA plans the rules were supposedly trying to protect, in that one way to solve the conundrum has been to allow unlimited non-ERISA investment while simply barring investment from all ERISA plans.

Thus, while the balance reflected by the 25 percent test to pursue a principled fiduciary-based analysis may have made sense on some level, the laboratory of the marketplace once again showed that a proper balancing of all competing interests, taking into account administrability and other practical considerations, informed a different balance. The new test, which is much more in the nature of a traditional de minimis test, but which continues to use the basic structure and formulation initially established by the Department of Labor in 1986, would allow those attempting to use ERISA-compliant structures to focus on the extent of investment by plans subject to the rules at issue (ERISA plans), rather than also focusing on plans to which the statute does not even apply (such as governmental and non-US plans).

Other Changes.

In addition to the foregoing, a number of other rules would be relaxed and tailored. The miscellaneous changes include amendments to or additions of rules relating to cross trading, block trading, electronic communication networks, foreign-exchange transactions, and the bonding of broker-dealers.

This author believes that Congress is to be commended for reacting to the evolution in the marketplace that has caused the application of a well-intended statute to become counterintuitive and the subject of ever-increasing criticism. Legal rules that impede transaction after transaction not perceived as abusive may bring out a tendency among practitioners and business people to seek out increasingly aggressive structuring solutions; workability, on the other hand, may encourage respect and voluntary compliance. Hopefully, these changes, which are summarized below, will refocus the statute, and the market and its advisors, on addressing fiduciary self-dealing and other wrongs, rather than a seemingly neverending procession of technical violations of broad prohibitions.

Prohibited Transactions--Generally

Relief for Certain Transactions Between Plans and Service Providers.

ERISA prohibits a broad range of transactions between plans and parties in interest, generally including sales, exchanges, leases, loans transfers, etc. As indicated above, under the Act there is a new exemption of potentially seminal significance given today’s marketplace, for certain transactions between plans and a party in interest (but not including the furnishing of goods, services or facilities and not including the acquisition of employer securities or employer real property) solely by reason of providing (or being affiliated with a provider of) services, other than a party in interest that is a fiduciary (or an affiliate) who has or exercises any discretionary authority or control with respect to the investment of the assets involved in the transaction or renders investment advice with respect thereto, if the plan receives no less (in a case in which the plan is receiving the consideration) and pays no more (in a case in which the plan is paying the consideration) than “adequate consideration.”¹¹ As a further part of this change, the definition of “adequate consideration” would be clarified for these purposes, so that it is clear that, under the new exemption, (i) in the case of a security for which there is a generally recognized market, factors such as the size of the transaction and the marketability of the security expressly may now be taken into account, and (ii) in the case of assets for which there is no generally recognized market, any fiduciary can make the applicable determination (rather than only a trustee or named fiduciary pursuant to the terms of the plan). (It is unclear the extent to which the existing rules may have in effect already been consistent with this clarification.) The question of whether a person is a party in interest “solely” by virtue of performing services may be the subject of future clarification regarding a number of factual permutations, including, for example, a situation in which a person that performs fiduciary services in respect of assets which may be held by the plan in question but which are not the assets involved in the particular transaction.

Correction Period.

The bill would provide for a 14-day correction period for certain transactions relating to the holding, acquisition or sale of a security or commodity where it is later discovered that such transaction was prohibited. The 14-day correction period would begin upon the discovery (or at the time at which discovery could have reasonably been made) that the transaction would be prohibited. The relief would not generally be available (i) in the case of transactions for employer securities or employer real property or (ii) in the event that a fiduciary or the party in interest knew (or reasonably should have known) at the time of the transaction that such transaction would be prohibited.¹²

This change may well make the administration of ERISA’s penalty provisions more rational. Where applicable, the new relief should provide reasonable opportunities for correction of inadvertent errors.

'Plan Assets'

The “plan asset” regulation,¹³ also discussed above, contains an exception that has come to be known in certain circles as the “25 percent test.” Under the 25 percent test, an equity interest of an entity (including an interest with substantial equity features) will not cause such entity’s assets to be deemed to be plan assets where equity participation in such entity by “benefit plan investors” is not “significant.”¹⁴ For these purposes, equity participation by benefit plan investors is “significant” if 25 percent or more of the value of any class of equity interests in an entity is held by benefit plan investors. Equity amounts held by a person with discretionary authority or control with respect to the assets of an entity or a person who receives a fee in exchange for investment advice are generally disregarded for purposes of determining if such participation is significant. The definition of “benefit plan investor” includes plans as defined in ERISA (whether or not subject thereto), individual retirement accounts (and similar vehicles) and entities that are deemed to hold plan assets. As noted above, these rules, which may seem relatively simple on their face, have caused substantial dislocation in the global marketplace.

The bill would legislatively change several aspects of the current plan asset rules. Critically, the definition of “benefit plan investor” would be limited to ERISA plans (and individual retirement accounts and similar vehicles), thus in effect positioning the rule more in the nature of a true de minimis test and hopefully enhancing its administrability and workability. (There had been a proposal not ultimately adopted to increase the applicable percentage from 25 percent; in this author’s view, the definitional change is far more significant as a practical matter and is of far more relevance in terms of the underpinnings of the rule.)

In addition, the rule has been modified so that an entity would be deemed to hold plan assets only to the extent of the percentage of the equity interests in the entity held by benefit plan investors; this change, which presumably applies for purposes of another downstream vehicle's test, should facilitate investment in markets in which commingled funds (e.g., a fund-of-funds) are becoming more common, and which should help address the counterintuitive result that non-plan assets in commingled funds were essentially counting against the 25 percent limitation of target portfolio vehicles in which such funds were investing. ¹⁵

Miscellaneous Changes

Exemption for Cross Trading.

The question of the extent to which a fiduciary or broker can effectuate cross trades involving one or more ERISA plans has been a difficult one. On the one hand, the efficiencies to the benefit of all parties can be significant; on the other hand, there are potentially difficult conflict issues. The Department of Labor has issued a class exemption covering certain cross trades¹⁶ and a second class exemption for cross trades involving model-driven and index funds,¹⁷ and has suggested the possibility of expanded relief for actively managed accounts.¹⁸ In at least one case, a high-profile enforcement action implicated cross trading.¹⁹ Because of self-dealing considerations, these issues can arise even if no brokerage fee is paid.

The bill would codify additional relief for cross trades. Under the bill, cross trades would be exempt from certain prohibited transaction rules if (i) the transaction is a purchase or sale for no consideration other than cash payment against prompt delivery of a security for which market quotations are readily available, (ii) the transaction is at the independent current market price of the security, (iii) no brokerage commission, fee (except for disclosed customary transfer fees) or other remuneration is paid in connection with the transaction, (iv) the cross trading program is pre-approved by another plan fiduciary after disclosure, (v) each plan (or, as applicable, master trust of a single employer or controlled group) involved has assets of at least $100 million, (vi) quarterly reports with required information are provided, (vii) the manager’s fees are not based on consent to cross trading, and, generally, no other service is conditioned on such consent, (viii) the manager’s policies and procedures regarding cross trading meet certain requirements, and (ix) the manager has designated an individual responsible for reviewing and annually reporting (under penalty of perjury) on certain matters relating to cross trading.²⁰

Exemption for Block Trading.

A new exemption for block trading would apply to any transaction involving the purchase or sale of securities between a plan and a party-in-interest if (i) the transaction involves a block trade (i.e., a trade which will be allocated across two or more client accounts of a fiduciary) of at least 10,000 shares or $200,000; (ii) at the time of the transaction, the interest of the plan (together with the interests of any other plans maintained by the same plan sponsor), does not exceed 10 percent of the aggregate size of the block trade; (iii) the terms of the transaction, including the price, are at least as favorable to the plan as an arm’s-length transaction; and (iv) the compensation is not greater than that associated with an arm's length transaction with an unrelated party.²¹

Exemption for Electronic Communication Networks.

In 2004, the Department of Labor issued a favorable Advisory Opinion regarding electronic communication networks (“ECNs”).²²

The bill would codify relief for ECNs from the prohibited transaction rules. Under the new exemption, transactions involving the purchase or sale of securities (or, if applicable, certain other property) between a plan and a fiduciary or a other party-in-interest will broadly be exempt if (i) the transaction is executed through an exchange, ECN, alternative trading system, or similar execution system or trading venue subject to regulation and oversight by the applicable federal regulating agency or other applicable foreign governmental regulating agency; (ii) (A) the transaction is effected pursuant to rules designed to match purchases on sales at the best price available through the system in accordance with applicable governmental rules, or (b) neither the execution system nor the parties to the transaction take into account the identity of the parties in the execution of trades; (iii) the price and compensation associated with the purchase and sale are not greater than an arm's length transaction with an unrelated party; (iv) if the party in interest has an ownership interest in the trading system or venue, the trading system or venue has been authorized by the plan sponsor or other fiduciary for applicable transactions; and (v) the plan administrator is provided with at least 30 days' notice of intial execution.²³

Relief for Foreign Exchange Transactions.

The Department of Labor has previously issued prohibited transaction class exemptions for foreign exchange (“F/X”) transactions that meet certain requirements.²⁴ The bill would codify an exemption for F/X transactions between a bank or broker-dealer (or any affiliate of either) and a plan to which it is a trustee, custodian, fiduciary, or other party in interest, such exemption broadly to apply if (i) the transaction is in connection with the purchase, holding, or sale of securities, (ii) at the time the transaction is entered into, the terms of the transaction are not less favorable to the plan than the terms generally available in comparable arm’s-length F/X transactions between unrelated parties, or the terms afforded by the bank or the broker-dealer in comparable arm’s-length transactions involving unrelated parties, (iii) the exchange rate used by the bank or broker-dealer or affiliate for a particular F/X transaction does not deviate by more than 3% from the interbank bid and asked rates at the time of the transaction as displayed on an independent service that reports rates of exchange in the foreign currency market for such currency, and (iv) the bank or broker-dealer (or affiliate) does not have investment discretion or provide investment advice with respect to the transaction.²⁵

Bonding.

ERISA generally requires so-called “plan officials” to be bonded as set forth in the statute and regulations. The Department of Labor had at one time proposed an exemption from the bonding requirements for certain broker-dealers,²⁶ but this exemption never was adopted. Under the H.R. 4, the bonding requirements would not apply to an entity that is registered as a broker or a dealer under Section 15(b) of the Securities Exchange Act of 1934, as amended, if the broker or dealer is subject to the fidelity-bond requirement of a so-called “self-regulatory organization.”²⁷ The changes to the bonding rules would not be effective until years commencing after enactment.

The Future Contributions of the Funding Legislation

It will now be seen how the above-described rules contributed by the new funding legislation will be judged after they are tested in the continuing laboratory of the marketplace, just as the rules in effect until now have been tested over the years. Practitioners may even increasingly be in the position of advising on issues that their clients appreciate and understand, rather than on problems caused by a series of absolute inflexible prohibitions and other technical impediments. As still further refinement evolves over time, maybe ERISA can get back to the business of addressing the real problems of fiduciary self-dealing and other malfeasance at which it is so laudably directed.

¹ The provisions of the bill were generally intended to be part of the conference report for H.R. 2830. However, the bill that was passed was H.R. 4, a new bill that did not contain some of the tax provisions of H.R. 2830 (109th Cong., 2d Sess. (2006)).

² E.g., ERISA §406 (relating to prohibited transactions); 29 C.F.R. §2510.3-101 (relating to which assets are “plan assets”).

³ ERISA §§406, 502(i);I.R.C. § 4975.

⁴ ERISA §408(b)(17), as added by H.R. 4 §611(d)(1);I.R.C. §4975(d)(20), as added by H.R. 4 §611(d)(2).

⁵ ERISA §408(b)(20), as added by H.R. 4 §612(a);I.R.C. §4975(d)(23), (f)(11), as added by H.R. 4 §612(b).

⁶ 29 C.F.R. §2509.75-2.

⁷ 29 C.F.R. §2510.3-101.

⁸ 29 C.F.R. §2510.3-101(f).

⁹ See generally 50 Fed. Reg. 961, 966 (1985).

¹⁰ ERISA §3(42), as added by H.R. 4 §611(f).

¹¹ ERISA §408(b)(17), as added by H.R. 4 §611(d)(1);I.R.C. § 4975(d)(20), as added by H.R. 4 §611(d)(2).

¹² ERISA § 408(b)(20), as added by H.R. 4 §612(a);I.R.C. §4975(d)(23), (f)(11), as added by H.R. 4 §612(b).

¹³ 29 C.F.R. §2510.3-101.

¹⁴ 29 C.F.R. § 2510.3-101(f).

¹⁵ ERISA §3(42), as added by H.R. 4 §611(f).

¹⁶ Prohibited Transaction Class Exemption 86-128.

¹⁷ Prohibited Transaction Class Exemption 2002-12.

¹⁸ See, e.g., 67 Fed. Reg. 6614, 6629 (2002).

¹⁹ Reich v. Strong Capital Management Inc., No. 96-C-0669 (E.D. Wis. June 6, 1996) (reportedly settled in 1996 for almost $7 million).

²⁰ ERISA §408(b)(19), as added by H.R. 4 §611(g)(1);I.R.C. §4975(d)(22), as added by H.R. 4 §611(g)(2).

²¹ ERISA §408(b)(15), as added by H.R. 4 §611(a)(1);I.R.C. §4975(d)(17), as added by H.R. 4 §611(a)(2).

²² Dep’t of Labor Adv. Op’n 2004-05A (May 24, 2004).

²³ ERISA §408(b)(16), as added by H.R. 4 §611(c)(1);I.R.C. §4975(d)(19), as added by H.R. 4 §611(c)(2).

²⁴ Prohibited Transaction Class Exemption 94-20; Prohibited Transaction Class Exemption 98-54.

²⁵ ERISA §408(b)(18), as added by H.R. 4 §611(e)(1);I.R.C. § 4975(d)(21), as added by H.R. 4 §611(e)(2).

²⁶ 52 Fed. Reg. 31039 (Aug. 19, 1987) (withdrawn Feb. 24, 1992).

²⁷ ERISA §412(a)(2), as added by H.R. 4 §611(b).