BNA Pension and Benefits Blog

Trying to be somewhat current and topical, with a vote scheduled this week in the House Education and Labor Committee on Rep. Miller's 401(k) Fair Disclosure for Retirement Security Act bill (HR 3185) and the DOL moving forward with proposed rules addressing these issues, I just wonder what the ultimate impact will be at the participant level.  While there will be much gnashing of teeth at the disclosure pains by the investment and plan community, will participants perceive this as something beneficial and worth all the effort?  My guess is no.  Given my experience with most participants, their focus is first on a relatively safe investment (which is not necessarily good) and second on an acceptable rate of return.  While they may be interested in knowing what the true expenses of operating a plan might be and to what extent revenues from their investment decisions are being used to pay these amounts, it will probably have little impact on their investment decisions.  Granted there may be a focused minority of participants who will pay close attention to this and will alter their decisions based on what they perceive, but I suspect the majority will not do much.  I'm interested in what others may feel on this point.  Are wheels spinning for not that much good?

Last month the Supreme Court resolved, at least for one case, this question: Do individual employees have a cause of action when a fiduciary violates its responsibilities with respect to the assets in an individual’s defined contribution account? In the case, LaRue v. Dewolff, Boberg & Associates, Inc. (42 Empl. Benefits Cas. 2857), the Court held that an individual does have a cause of action. The judgment was unanimous, but Justice Roberts wrote a mystifying and mischievous concurring opinion, joined by Justice Kennedy, which might raise a question as to whether the issues purportedly addressed by the Court are really settled.

The case involved straightforward facts: a participant in a defined contribution plan gives investment instructions with respect to his account. The plan fiduciary, to whom the instructions were given, does not follow them. The account suffers a loss, and the participant brings a civil action against the fiduciary to recover the loss. Does ERISA provide jurisdiction for such a civil action?

The fiduciary argued no, because relief against a fiduciary (except for equitable relief) is available only if the fiduciary caused harm to the entire plan , as opposed to this situation in which the harm was to a participant. This argument was quite plausible given earlier Supreme Court decisions interpreting the scope of ERISA Sections 502(a)(2) and 409. (Section 409 provides, in part, that a fiduciary “is liable to make good to [the] plan any losses to the plan resulting from” the fiduciary breach.)

The Court, though, said that the loss in this case--even though felt by only a single plan participant--was still a loss to the plan under Section 409.

My initial reaction to the decision recalls a quote from “The Godfather,” when Marlon Brando, presiding over a meeting of the five families to establish a peace, asks “How did things ever get this far?” How could we, more than 30 years after ERISA, still be debating whether a participant in a defined contribution plan has a cause of action against a fiduciary whose breach reduced the value of the employee’s account?

But now, thanks to LaRue, the issue is settled. Or is it?

Justice Roberts wrote separately. His opinion says that LaRue’s true claim was a claim for benefits under Section 502(a)(1)(B) of ERISA and that “it is at least arguable that a claim of this nature properly lies only under § 502(a)(1)(B). . . . If LaRue may bring his claim under § 502(a)(1)(B), it is not clear that he may do so under § 502(a)(2) as well.”

Justice Roberts says this is important, because under Section 502(a)(1)(B), it is clear that a participant ordinarily has to exhaust administrative remedies and that a plan can grant a fiduciary a significant degree of discretion in determining benefit eligibility and the meaning of plan terms.

Although Justice Roberts does not expressly say so, it is also possible that if the action is under section 502(a)(1)(B), there may be no relief at all—LaRue’s action was an attempt to get the fiduciary to make good the plan’s loss; how would that be possible under section 502(a)(1)(B), where the fiduciary would not even be the proper defendant? (Maybe if there is a loss, the loss would have to be recovered ratably from the accounts of all participants. Now that would be a happy result for the other participants. Now could they bring an action against the plan fiduciaries for not suing the fiduciary responsible for causing LaRue a loss? And would that be actionable only under section 502(a)(1)(B), since they are basically saying the same thing that Justice Roberts says Larue is saying: “My benefit should be larger”? I can see an endless cycle of complaints here.)

The most unfortunate thing about Justice Roberts’ concurrence is that it ensures us a new period of uncertainty. Certainly every fiduciary defendant will seize on Justice Roberts' words, and courts will have to figure out just what the concurrence means and if any Justices, other than Justices Roberts and Kennedy, may in the future be sympathetic to the concurrence’s rather odd position.

I should add that it is particularly odd, given that Justice Roberts, at least in his confirmation hearings, suggested that he wanted the Court to speak, as often as possible, with a single voice. In LaRue, he opts for point, counterpoint.

[Ed. Note: For coverage of the LaRue decision see 34 Pens. & Ben. Daily (Feb. 21, 2008); 35 Pens. & Ben. Rep. 467  (Feb. 26, 2008); and 42 Empl. Benefits Cas. 2857.]

As expected, the 401(k) fee disclosure case against Deere & Company was the first to be decided, since the District Court for the Western District of Wisconsin has a reputation as a "rocket docket."  Many people, myself included, had thought the complaints in these 401(k) fee cases contained sufficient fact allegations that courts would wait until after discovery to decide them. Unexexpectedly, the court dismissed the case based on the complaint and the plan documents. Hecker v. Deere & Co., Case No. 06-C-719-S (W.D. Wisc. June 21, 2007). The facts of the Deere plan may, however, distinguish it from most other plans and make it less significant as a precedent in the other pending 401(k) fee cases, at least at the motion to dismiss stage.

The SPD provided that:

The costs of administering the Plan are paid by the Company. Participants incur no transaction fees or sales loads on funds purchased and sold through the Plan’s standard plan options.... All fund investors indirectly pay any fund-level expenses, such as management fees, asset-based sales charges (12b-1 fees), and other fund expenses, as detailed in the fund’s prospectus....

Of the 26 funds specifically offered by the plan, 23 were Fidelity Funds. However, the plan also offered a mutual fund brokerage account through which participants could select from among 2500 other mutual funds unaffiliated with Fidelity. Fidelity received direct payment for its trust services from Deere; the plan paid no additional fees to Fidelity.

The court concluded that:

The disclosure in the reports and prospectuses accurately reflect the expenses actually paid to the fund manager for fund management as evidenced by the allegations that the same fees are charged to all retail fund customers. To the extent that the charge includes profit, it is unlikely that the fund sponsor would know or be in a position to control its redistribution among related corporations, corporations, a fact conceded in defendants’ brief. There is no evidence of intent in the statute or regulations to reach this type of detail.

The court found that the recent proposals to expand disclosure of indirect fees and provide additional disclosure supported the conclusion that such expanded disclosure is not required under current law.

There appears to have been no dispute that the Deere plan satisfied the ERISA section 404(c) requirements other than requirements related to fee disclosure. The court concluded that the existing regulations do not require disclosure of revenue sharing, only the amount of the fees which were adequately disclosed. Nor did the court feel that disclosing the revenue sharing arrangements would have enhanced the participants' investment decisions:

In assessing the likely return on an investment the fees netted against the return are certainly relevant, but knowing the subsequent distribution of those fees has
no impact on the investment’s value.

The court concluded that the participants had adequate opportunity to choose funds other than the designated Fidelity Funds because of the mutual fund brokerage window and therefore their investment in the designated funds and therefore they exercised the requesite control over the investments in selecting the Fidelity Funds to insulate the Deere fiduciaries from any liability under section 404(c)'s safe harbor even if the plaintiffs could prove that the fees in the Fidelity Funds were excessive.

Most plans don't offer a brokerage window, so the Deere case is clearly distinguishable. However, the court's conclusions about the extent of disclosure required under current law, both under the general ERISA provisions and section 404(c), would protect most plan fiduciaries if followed by other courts. Stay tuned for the rest of the story, since there are still a number of these cases pending.

Uncertain Tax Positions and Compensation

As if there isn’t enough change going on – revised SEC disclosures, potentially 400 pages of “final” 409A regulations, revised accounting standards for equity compensation, proposed legislation limiting the amounts of deferred compensation, ad nauseum. Benefit’s advisors must also deal with subtle and unexpected changes, like “FIN 48.”

Like many other recent accounting standards, this new requirement has developed in response to what many perceived as “abuses” in business tax and accounting practices. You may agree or disagree with that perspective, but the reporting position is now fact and you or your clients will have to deal with it.

Basically what this standard requires is that each entity subject to audit under generally accepted accounting principles assess their income tax position on all material items of income and expense.  Any position taken on the tax return must generally satisfy a more likely than not standard of success. In assessing the likelihood of success, it is assumed that the applicable tax enforcement group is reviewing the position, has all the facts available and is familiar with the applicable law.

If a tax return position does not meet the more likely than not standard, the company must measure the potential impact on their tax liability and adjust their financial statements accordingly. There is also additional financial statement disclosures required relative to this standard.

This statement has very comprehensive impact. It applies to any entity that MAY owe a tax liability. That means it can apply to taxable entities, certain pass-through entities and tax-exempt entities (either because of unrelated business tax issues or the potential loss of tax-exempt status.)  That means that this standard applies not just to employers, but also to their benefit plans. That is an important point because an issue may be immaterial to the employer, but significant to the plan.

The standard is currently effective for publicly traded companies and will apply to private enterprises for year beginning on or after December 15, 2006.  However, the standard does effectively apply to positions taken on returns that are currently in process, as the liability assessment is based upon all open years, not just the current year.  Also, in assessing any potential liability, the amounts of interest or penalties are also to be included.

This posting is not intended as a detailed analysis of the new standard. This is not the appropriate medium for that.  Most accounting firms have been doing web based training on this standard and you can check those out to get detailed information. What I intend to cover over this week is various areas of compensation planning that can result in issues that must be reviewed for potential measurement under this standard. There are many, many areas related to compensation and benefits.  Some of which are so familiar, that we may have forgotten that they do not reflect settled law where it is easy to get to a more likely than not standard. Also, this will help explain some of the calls you may be receiving from your clients.

Caveat:  My background is largely private companies. I am hoping that other members of the advisory board will chime in on public company concerns.

The Basics

1. Reasonable compensation:  The deduction under IRC Section 162 is limited to reasonable compensation for services. Amounts paid in excess of this reasonable limit are not deductible. How much work have you or your client done to get comfortable that the level of compensation being paid is reasonable at a more likely than not standard of success?
2. Deduction for accrued bonuses:  The temporary regulations under IRC Section 404, as well as the proposed regulations under IRC Section 409A, provide a haven from the classification of a payment as deferred compensation, if it is paid within 2 ½ months of the end of the tax reporting period. But, many employers take that as a safe harbor and fail to take other steps to demonstrate that the bonus was, in fact, accrued as of year-end. If reasonable, the risk associated with this matter may just be a timing different, but it still must be analyzed under FIN 48.
3. Entertainment Expenses:  IRC Section 274 sets some very rigorous and mechanical standards controlling the deductibility of travel and entertainment expenses. Amounts outside of these limits are not deductible.  Frequently employer’s programs fail to capture this information and apply the appropriate limits on the tax return.  There are also some soft issues in this area with respect to the allocation of costs, etc.

Tomorrow we will cover some of the executive compensation issues.

As 401(k) plans become the major source of retirement savings,  Congress, GAO, DOL and the SEC are all turning their attention to the issue of 401(k) fees. Last fall, Gao issued a reprt on Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees at the request of Congressman George Miller, now Chair of the House Education and Labor Committee.  Last week, the Committee held a hearing on "Hidden 401(k) Fees Undermining Retirement Security?"  If you missed the hearing, you can view it on line at the Committee's website, where the written testimony of the witnesses is also posted.

The DOL has indicated that they will be launching a number of new initiatives to increase disclosure of 401(k) fees, particularly the payment of indirect fees to service providers. The DOL has already proposed a revision of  Schedule C of the Form 5500 which would require annual disclosure of indirect fees. Recognizing that plan fiduciaries often have difficulty getting information about indirect fees, the Department is planning to propose an amendment to the statutory prohibited transaction exemption that permits service providers to be paid (ERISA section 408(b)(2)) to require service providers to provide information about indirect compensation so that plan fiduciaries can determine if their total fees are reasonable. The Department is also expected to issue a request for informtion about 401(k) disclosure of fees, both direct and indirect, to plan participants.

Meanwhile, in a speech to the ABA Business Law Section last week, Andrew Conohue, Director of the SEC's Division of Investment Management, indicated that the SEC is working with the DOL to determine how fee disclosure should be made to 401(k) plan participants. He also indicated that the Commission staff is reviewing the rule that permits mutual funds to pay 12b-1 fees.

Plan fiduciaries should be continuing to request information about indirect fees from service providers such as investment managers, investment consultants, recordkeepers and trustees to determine whether the fees paid by their 401(k) plan are reasonable. Since many fees paid by 401(k) plans are asset based, fiduciaries should review the total paid annually as plan assets grow. Also, fiduciaries should move to institutional shares of mutual funds as their investments reach the minimums for such shares. Finally, fiduciaries should benchmark the fees they are paying against industry averages.

Fiduciaries shouldn't lose sight of the fact that the key is the return participants are getting net of fees, so fees shouldn't be the only consideration. However, compared on a net basis, lower fees will often result in better performance.

ERISA fiduciary litigation isn't calming down, it is just switching subjects.  As the stock drop cases  wind down, they will be replaced (in fact, are already being replaced) by hidden or excessive fee cases.  This should really come as no surprise to anyone.  Most of us in the industry have known about these hidden payments (commissions, shelf space fees, etc.) for years, but never mentioned them in polite society. 

It took Elliott Spitzer to shine a light on these arrangements and, once he did, virtually everybody agreed that they were indefensible (not that service providers shouldn't get paid, but that their fees should be known to the payor, who would then be in a position to comparison shop).  Now everybody is getting into the act.   Both the SEC and DOL are acting as though they just found out that these arrangements exist and are telling plan fiduciaries to ask questions.  DOL is going to require greater disclosure on Forms 5500 and is considering amending the section 408(b)(2) regs. to require knowledge of fees as a pre-condition to a determination of reasonableness. 

If only it were that easy.  No matter how much disclosure the government may require, people will figure out new ways to be paid.  In fact, there are so many ways now, that full disclosure would probably create something as difficult to prepare and read as a prospectus.  Great for the service providers who prepare them, but of little practical use to plan fiduciaries, let alone participants. 

In my view, for greater disclosure to become effective, it must be accompanied by greater simplicity.  I don't think either DOL or the SEC currently has the authority to dictate how fees will be paid (as long as prohibited transactions are avoided), and the chances of Congress passing an ERISA equivalent of a truth-in-lending disclosure statement appear nil.  This doesn't mean that the problem won't be solved.  It just means that the problem will be solved by class action litigation--a boon to the lawyers, but to no one else.

What I don't understand is why the industry groups, such as ICI or ACLI don't come forward to take the lead.  This can easily be accomplished by standardized disclosure statements coupled with a commitment to receive or pay no fees not covered by those statements.  This would probably be a net plus to the members of those associations, since, I assume, mutual funds and insurance companies pay more secret fees and commissions than they receive. 

It seems to me the end result is both inevitable and desirable--full disclosure (in an understandable form) of all fees paid or received by a service provider in connection with a plan's business.  There are four ways to get there; legislation, litigation, regulation (to the extent possible) and industy initiative.  The latter, I think, is most desirable, but least likely to occur.  The least desirable is litigation, and that is how I think it will happen. 

Any thoughts or comments?

This posting comes in from a different perspective - that of the benefit plan auditor.  Since the reporting season for the calendar 2005 plan year is pretty much over, I thought it might be valuable to go over some of the problems that cropped up this year on such audits.  After nearly 30 years of doing these audits, one would think that the audit requirement would be pretty well understood by now and the season would flow very smoothly.   I shouldn’t be saying that the season is “pretty much over.”  It should be just plain over.

Such was not the case this year.  At an AICPA committee meeting last week,  practice leaders from some of the nation’s largest CPA firms agreed that there were more Forms 5500 filed without audit reports this year than any year that they could recall.  Surprisingly, in early October 2006, all were receiving requests for proposals for calendar 2005 or earlier plan audits.

What is up with this? 

First, the plan audit process is a lot more complicated than it used to be and over the next several years, plan sponsors are going to find it even more complex.  Today the complexities arise from paperless systems, HIPAA and other privacy considerations, mergers and acquisition activity, service providers' desire to protect what they see as their proprietary interests and changing investment arrangements.  This has resulted in many audit firms leaving the business of doing plan audits or, at least, culling their client lists.  That means that many plans are changing auditors unexpectedly and, often, late in the game.  Hence, we have the problem with too many incomplete filings this year.

But that is not the only reason.  There were simply a lot of problems this year.  I wanted to take advantage of this space to give the readers some free advice on working with their benefit plan auditor.

1. Arrange a meeting with your plan auditor in the next couple weeks to plan next year’s audit.
2. Review problem areas from the prior plan year and what can be done to eliminate them.  Common problem areas this year included:
   1. Plan documents that did not conform to the plan’s operation.  This seems to be a trend as more and more sponsors shift to prototype or volume submitter plans.  Those nuances of plan operations that were embedded in their individually designed plans persist in operation, but were omitted from the restated version of the plan.
   2. Operational defects:  Though annoying to discover, wouldn’t you rather know now that your system has omitted eligible employees, enrolled ineligible, used the wrong definition of compensation or any one of the hundreds of things that can go wrong with the plan’s operations?  Remember, an audit is based upon sampling, so there is no assurance that all operational defects will be identified.  Just be grateful for the ability to promptly address those items that are discovered.
   3. Privacy and confidentiality agreements:  The auditor is obligated by ERISA to follow generally accepted auditing standards.  That means the auditor must look at statistically valid samples of the operating data of the plan.  The terms under which the auditor is granted access to this information should be set as soon as possible with all parties responsible for the plan’s operations.  Once set, such terms should remain in place until there is a change in the parties involved or a change in the law. 
   4. Plan combinations:  It is a simple thing for an auditor to audit a rollover.  But, when an entire population is entering a plan with all of the history associated with the prior plan, the plan sponsor’s duties increase and so do the auditor’s.  So, talk about any such activity during a planning session.
   5. System changes:  Because of the paperless environment, auditors rely heavily on the controls built into electronic systems, so make sure you advise your auditor of any such changes. 
   6. Hard to value assets:  ERISA requires that plan assets and liabilities be reported at fair value.  For plans that invest in publicly traded vehicles that is not a problem.  But, recently plans have again started investing in arrangements for which there is no active market – real estate partnerships, hedge funds, etc.
   7. Late deposits:  This has been an irritant in the audit process for nearly a decade now.  What does it mean for funds to be deposited as “of the earliest date on which such contributions can reasonably be segregated from the employer's general assets?” If I had to pick the two worst areas of audit controversy, it would be the privacy or confidentiality agreements for welfare plan audits and timeliness of deposits for 401(k) plans.  In this latter case, the sponsor needs to recognize that the auditor is required by GAAS to look at related party transactions and to reach some conclusions on their status as exempt or not.  Further, there is no materiality standard for the ERISA schedule of non-exempt transactions.  I can confidently tell you that auditors don’t like doing this piece of the work any more than the sponsor enjoys hearing about it. 
      
      Different audit firms have different approaches to this area.  In all cases, the audit files need to include evidence which supports the conclusion that deposits are or are not made on time.  This standard varies from the standard the auditor is allowed to apply on tax matters.  There the auditor is merely instructed to take action in the event something comes to his or her attention.  With regard to prohibited transactions, the auditor is required to make specific inquiries and draw specific conclusions. 
3. Keep the communication lines open on plan amendments, government audits or inquiries, system changes, addition of new service providers, etc.  I realize that it is an audit, but don't try to bury stuff just to see if the auditor can find it.  Please.
4. Agree upon a schedule of what data will be required and when.

I recognize that when you look at many of the problem areas for the year, it appears that the auditor has an adversarial relationship with the sponsor.  That is not intentional.  It is grounded in the fact  that ERISA requires that the audit be conducted for the benefit of the participants and beneficiaries.  The auditor should simply be living up to their arrangement letter.

Dana Muir, a professor at University of Michigan’s business school, has co-authored an interesting article on the use of the efficient market hypothesis in two areas, one of which relates to ERISA retirement plans that hold employer stock.  (The other part of the article, which was written Cindy Schipani, looks at EMH in the context of shareholder appraisal cases.  Its interesting, but it is not ERISA, so barely warrants a reading by the ERISAphiles reading this blog.) 

In the ERISA side of the article, Professor Muir is interested in what happens in plans—usually 401(k) plans—that are holding employer stock, and in the normal scheme of things would be purchasing more employer stock, when continuing to hold the stock, and certainly to continue to purchase it, is, at least arguably, imprudent.  And Professor Muir is particularly concerned with the responsibilities/plight of a directed trustee, whose directions are to continue to hold and to continue to buy.  When should the directed trustee ignore those directions because they are in violation of the statute?  Since one of  ERISA’s statutory commands to fiduciaries is to act prudently, presumably the fiduciary should refuse to honor the directions to purchase employer stock and should consider selling at least some of the employer stock if the fiduciary believes, or should believe, that the stock (at least if held in large amounts) is not a prudent investment for the plan.

This is an issue of multiple dimensions and extraordinary complexity.  Professor Muir is interested in several aspects of that issue, but her portion of the article is focused on the Department of Labor’s 2004 field assistance bulletin (FAB 2004-03) on when directred trustees may satisfy their fiduciary responsibilities simply by following the directions given to them.  The FAB indicates that under EMH, the price of securities reflects all known public information about the securities (this is the semi-strong version of EMH, since it does not assume that the price reflects nonpublic information), and thus that directed trustees generally have no duty to second-guess directions, since the directions are to purchase the securities at the “correct” price.  The only exceptions that the FAB recognizes from this generally free pass to uncritically follow directions are when the directed trustee has nonpublic information or when public information calls into “serious question a company’s viability as a going concern,” or perhaps when there is public information that shows that the company, its officers or directors have been formally charged by state or Federal regulators with financial irregularities. 

The reason for these exceptions (except the one dealing with a fiduciary who has nonpublic information) is not entirely apparent from the FAB, but might be either that in such situations the market cannot accurately gauge the value of the stock (but why that would be so is itself not clear if you believe in the version of EMH that DOL apparently believes in), that a company that may lack viability as a going concern is not (at least in large concentrations) a suitable investment for a retirement plan, even given that Congress has generally exempted investments in employer stock from ERISA’s diversification requirement, or that the directions—which likely come from individual employed or related to the plan sponsor—may be polluted by the dishonesty of the individuals who are engaging in financial chicanery.

Professor Muir is concerned that the FAB, which purports to be based on EMH, reflects a primitive view of EMH and ignores the substantial economic work that claims EMH is not nearly so robust as the DOL apparently believes.  (That word, robust, has become a trendy adjective; it may be a bit overused these days.)  In fact, as Professor Muir notes, not all publicly traded securities always trade in an efficient market.  Research has shown that, for example, market noise, behavioral departures from economically rational behavior, short-selling in certain markets, can result in temporarily inefficient markets.  Indeed, as Professor Muir notes, “in other contexts, courts and policy makers are far more skeptical of the robustness of EMH than is the DOL.”   Professor Muir observes that in Delaware, for example, in appraisal cases, courts consider whether the market for a particular security appears efficient. 

How we construct a meaningful legal standard for directed trustees out of all this is of course not simple, and there are various competing policy considerations.  But the Department of Labor suggests that the issue is easy to resolve because of the DOL’s naive and dated understanding of EMH.

Professor Muir points out that courts, unfortunately, have given considerable weight to the views reflected in the FAB.  Another interesting question, which I know Professor Muir is concerned about from conversations with her, is why the Department’s views were presented in an FAB rather than in a regulation project, which would have been subject to public comment. 

The article, which will be in Michigan Law Review in June of next year, is easily worth the time and cost to download and read it.  It is on SSRN, and you can get there by following the links from Professor Muir’s biography page:  http://www.bus.umich.edu/FacultyBios/FacultyBio.asp?id=000279015.  Or you can probably call her for a copy.

In the interest of full disclosure, I am a big fan of Professor Muir’s work.

The ERISA Advisory Counsel has devoted one of its study projects this year to issues surrounding the prohibited transaction rules and hedge funds (and also cross-trading).  The basic problem, as the study group has framed it, is that the Department of Labor's plan asset regulations characterize the underlying assets of a hedge fund as plan asssets if immediately after the most recent aquisition of any equity interest in the fund, more than 25% of the equity is held by benefit plan investors.  (This is a slight but for our purposes irrelevant simplification of the actual rule.)  So significant investments by plan investors make the otherwise largely unregulated hedge funds subject to ERISA regulation.  Being subject to ERISA regulation can make it difficult for a hedge fund to operate, particularly in complying with the prohibited transaction rules.  (It should be said, contrary to the belief of some, that the plan asset regulations do not use the term "hedge fund.")

The study group held two days of testimony.  The first day was largely given over to representatives of groups that favor changing the plan asset regulations in a way that would allow more plan investors to hold interests in a hedge fund without the hedge fund being subject to ERISA regulation.  (The Pension Protection Act of 2006 has already softened the impact of the plan asset regulations, but retains the 25% threshold, although with a more limited definition of plan investor.)  The witnesses argued that hedge funds can be an acceptable plan investment, that the regulations' treatment of hedge funds was different than its treatment of certain venture capital and real estate asset pools, that hedge funds were subject to state law and federal securities fraud laws, and that the plan-asset regulations were promulgated almost two decades ago and that there has been a sea change in the investment universe since then. 

On the second day of testimony, there were at least two witnesses who were somewhat skeptical of the desirability of changing the plan asset regulations to accommodate greater plan investments in hedge funds.  Ironically, the second day of testimony occurred on the day after Amaranth announced it had lost three billion dollars of its investors' money.  I was one of the skeptical witnesses.  (Damon Silvers was another.)

I thought I would use this blog to expand the audience for my testimony from the advisory council members and the few outside attendees to the perhaps the slightly larger and only slightly overlapping world of readers of this blog.  I stipped the testimony of its first paragraph (the one saying how I am the author of articles and books and teach at the University of Alabama and am a visiting professor at Vermont Law School), but reproduce the rest of my testimony below (including a few paragraphs on the other topic the study group was looking at: cross-trading).  Although the hedge fund issue has a number of interesting aspects, I am particularly interested in thoughts about what plans, if any, should be investing in hedge funds, and when and for what purpose.

Anyway, here is the testimony (double-spaced no less):

I appreciate the opportunity to testify before you today on the important topics that this work group is studying: the plan asset regulations, and particularly how they affect the ability of employee benefit plans to participate as investors in hedge funds; and cross-trading.  It is also always a pleasure to testify before the advisory council, something that I think is especially true for those of us who are advisory board alumni   

            I should mention up front that my comments today are my own and in no way reflect the views of the University of Alabama, which I should add has won, although not in convincing fashion, its first three football games of the season. 

Vermont Law School does not have a football team, but it does have its own wonderful tradition of

stunning fall foliage. 

            I mentioned that it is a pleasure, as an advisory council alum, to offer you my comments today.  But it is even more of a pleasure to appear before you with an opportunity to play the role of Old Testament prophet, railing against the abandonment of the first and second of ERISA’s fiduciary commandments:

            First, honor the principle that where there is an opportunity for fiduciaries or parties-in-interest to exploit a conflict of interest, some will do so; and

            Second, recognize, always, that some fiduciaries will do really dumb stuff unless the law makes it really hard to do really dumb stuff.

            These two commandments lead me to conclusions about each of the topics you are studying today:

            On cross-trading, there is room for a thoughtful expansion of the ability of investment professionals dealing with plan assets to use cross-trading to benefit the plans, but generally speaking, only for large plans that have the resources and sophistication to protect their interests;

            On the plan asset regulations, do not change one iota of the current plan asset regulations to accommodate ERISA plan investment in hedge funds.  And I don’t say this just because Amaranth, the hedge fund, might be worth less today than Amaranth, the cereal I had for breakfast this morning.  I say it because it is not a good idea, at least not now, to tinker with the regulations, especially since the Pension Protection Act has already done some tinkering and we should give that tinkering time to cure. 

            Let me begin with some general observations about ERISA fiduciary law and ERISA investing—not the most common ideas, such as ERISA’s adoption of modern portfolio theory, and in particular, the benefits of diversification and the notion of total portfolio design as the proper context for judging prudence.  Those ideas are generally understood by sophisticated ERISA practitioners and scholars and have already been invoked by some of the other witnesses that have appeared before you.

            But one idea that is too infrequently articulated and often not fully appreciated is that with employee benefit plans, it is better to have rules that protect most plans against the possibility of large loss than rules that accommodate speculative or even innovative investment strategies that might produce above-market gains for some plans.  Departures from this principle can be disastrous for the participants in employee benefit plans.

            Another important idea that is sometimes overlooked, and that has some congruence with the “large loss” concern, is that ERISA plans come in varying sizes and ERISA fiduciaries and service providers with varying degrees of sophistication.  Rules that might be good with respect to one type of plan (a large plan, for example, utilizing the investment skills of highly regarded and experienced professionals) may not be good with respect to another type of plan (a small plan, for example,. that does not have easy access to sophisticated investment advice).

            With those two principles in mind, I am almost ready to turn to the topics at hand.  But I want to make one additional preliminary point: my thoughts on the plan asset regulations reflect not only ERISA concerns, but also some general concerns about hedge funds and investment markets generally.

1.  Cross-Trading

            Let me begin with cross-trading.  Cross-trading has obvious advantages to ERISA plans: it can reduce trading expenses.  It is, of course, true that over the last several years increased competition, industry innovation, and a DOL-supported fiduciary focus on plan expenses, have substantially lowered trading costs for plans.  So today there is less low-hanging fruit to be harvested through the use of cross-trading. But having said that, cross-trading, subject to appropriate regulatory constraints, can still save some plans money.

            But cross-trading has costs as well.  Let me mention three obvious costs:

            1.  Cross-trading can result in a favorable price to one party at the expense of another.

            2.  Cross-trading can result in investment managers causing a plan to sell or purchase assets in order to facilitate a trade with another plan, rather than to advance the plan’s own investment strategies.

            3.  Cross-trading can delay consummation of buy or sell transactions and thus lose the benefit of the market price at the time the buy/sell decision was made by the plan fiduciary.

            Obviously, practices that implicate the first two costs would be illegal under ERISA’s general fiduciary rules, but the general fiduciary rules are not as strong a deterrent to such practices as the prohibited transaction rules. 

            Large plans are equipped to protect themselves from illegal costs and to minimize the overall costs of cross-trading.  I suspect that many small plans are not in such a position.  Thus, any liberalization of cross-trading should create two regulatory regimes, one for larger plans, and one for smaller plans.  The regime for smaller plans should reflect likely aggregate gains and losses for small plans on the whole: better to impose modest additional costs on those small plans that have the ability to protect themselves from improper or unnecessary cross-trading costs than to impose such costs on plans that cannot protect themselves.  (Perhaps to cross-trade for smaller plans, an entity facilitating the cross-trades should be required to hire one or more independent fiduciaries to monitor its practices.)

            In addition, those professionals that facilitate cross-trading for plans should be required to provide client plans information about cross-trading on a regular basis, to allow the appropriate plan fiduciaries to monitor actual practice to ensure that the benefits exceed the costs.                       

2.  The Plan Asset Regulations and Hedge Funds

            I am skeptical that this is the appropriate time to revisit the interaction between the plan asset regulations and hedge funds.  For one thing, we have just seen yet another hedge fund absorb yet another spectacular loss in a moment’s time.  For another, Congress itself just liberalized the plan asset regulations in a way that will increase the opportunities for ERISA plans to invest in hedge funds. Given this, prudence alone dictates that we wait a decent interval before expanding still further the invitation for hedge funds to pursue ERISA plan investors.  Lets wait to see what happens from Congress’s liberalization before yet still further liberalization.

            Here are some reflections on why the 25% plan investor threshold should not, at least at this time, be increased.  (Indeed, I think a compelling case could be made to reduce rather than increase the threshold.)

            1.  I am skeptical of hedge funds as suitable investments for most investors, in part because of their lack of transparency, which is related to their immutability to the normal registration and disclosure rules applicable to most other securities.  To me, a hedge fund is a magic box: put your money in one end and out the other end comes dollar after dollar.  It is true that some funds have claimed spectacular returns, but other funds have lost almost unfathomable amounts of money. And I suspect—and this is only conjecture—that some of the large gains earned by some funds have come from two sources:

            First, the normal rules of chance—if you make large bets, you will win some of the time but over the long haul you will also lose some of the time.  Today’s winners look great, but two years from now they might not.  This was certainly the case for Long Term Capital Management and Amaranth. 

            Second, from inflated valuations of illiquid properties held by some hedge funds.  This may be the next great scandal waiting to happen, when we learn that many hedge funds did not generate mega returns after all.  Without more regulation, we cannot be certain that some of the amazing rates of return on investment have not been mere paper returns. This may be the hedge fund equivalent of cooking the books.

            2.  Hedge funds might, as some of your earlier witnesses have suggested, offer risk/return characteristics that can improve a plan’s overall portfolio.  This may be true, but if so, it is probably true only for, or primarily for, large defined benefit plans.  Any change in rules that applies to plans generally will inevitably result in the assets of smaller plans finding their way into some hedge funds. 

            3.  To paraphrase W. P. Kinsella, if more plan capital can be invested in hedge funds, there will be more hedge funds.  And if there are more hedge funds, there will be more lower-quality hedge funds, including some that are run by people who are not Nobel Prize laureates and perhaps some that are run by people spiritually linked to Tony Soprano.  And as certain as night follows day, these funds will end up with the assets of some employee benefit plans.  Moreover, a proliferation of hedge funds may have an unpredictable effect on capital markets, as they attract more capital away from more traditional investments.

            4.  One might have special concerns about so-called fund of funds, which is an umbrella fund that then purchases interests in actual hedge funds.  As I understand it, the appeal of hedge funds is that they offer unique investment strategies that can help plans hedge certain types of risk or that promise to provide high returns at low risk (now there’s a concept for you).  Given this, it is hard to see how a fund of funds would ever be a prudent investment.  Presumably, a hedge fund is a good investment if the particular fund fits the particularized needs of a particular plan’s portfolio.  A fund of funds is not a particular fund, and its appropriateness to a portfolio, and its value, will be extremely hard to assess.  Plus, funds of funds subject plans to two sets of fees and expenses.  Yet some of these funds already attract ERISA capital, and if the plan asset regulations are made more flexible they will attract still more ERISA capital.

            5.   Some witnesses have likened hedge funds to other “alternative” investments, i.e., real estate and venture capital pools.  But there is an important distinction between these investment vehicles and hedge funds: we know that these pooled investments are investing in real things: actual businesses or actual real property, not exotic swaps and large bets on currency fluctuations or the size of tiny expected spreads between related indexes.  Investors know what they are investing in with real estate and venture capital, at least more or less.  With hedge funds, investors know less and have less ability to judge the bona fides of a particular investment strategy, especially where the strategy is “proprietary” and not fully disclosed.     

            Indeed, plans may often find that their investments in a hedge fund are merely investments in the purported genius of its individual managers, a dangerous investment strategy.  And other plans may find that they are simply chasing last year’s spectacular returns.

            (It is also important to observe that venture capital pools are not exempt from the plan-asset regulations unless the pool is in fact actively involved in the management of at least one of the businesses in which the pool has invested.)

            6.  More hedge funds will mean more capital diverted from clearly productive use to bets on what will happen to the spread between March and April heating oil futures contracts.  This may not be a good trend to encourage by opening wider the ERISA doors to hedge fund investments.

            7.  Although this point may have been obliquely made in some of the earlier points, many small plans simply do not have the sophistication to evaluate hedge fund offerings; they will be the prey of the marketers of the lower quality funds that will almost certainly be released into the marketplace if the plan asset regulations are relaxed.

            8.  The current administration has championed defined benefit funding policies that would subtly encourage plans to develop portfolios in which assets more closely match plan liabilities, i.e., portfolios that are rich in secure fixed income securities that match the duration of plan liabilities and thus substantially tamp down interest-rate risk.  Inviting new plan investment in hedge funds seems curiously inconsistent with this policy.

            9.  For those hedge funds that are subject to ERISA, ERISA shines the most regulatory light on what are otherwise fairly secretive investment vehicles.  For those who believe in either transparency, or on the strongest constraints on the behavior of those who handle the retirement savings of other people, dimming that regulatory light may be problematic.       

            10.  Hedge funds may offer spectacular returns but sometimes return spectacular losses.  To return to one of my original points: for pension plans, it is better to have a rule that prevents some plans from experiencing devastating losses, even if it freezes the ability of a few plans to chase spectacular returns.  This is not to say that high-income investors should stay away from hedge funds; only that pension plans, which cannot afford large losses, should generally stay away from hedge funds.

3.  Conclusion

            There is always pressure to weaken ERISA’s fiduciary rules, to believe that the better angels of our nature are sufficient, in and of themselves, to restrain the self-interest of those who are entrusted to manage the retirement savings of other people.  We tend, as we look back at those wise men and women who drafted ERISA’s elaborate fiduciary protections (both in Congress and in the Executive branch), to think that they just didn’t realize that strict and sometimes unyielding constraints on fiduciary behavior has costs to plans.  But of course they realized this.  But they also realized that weaker, more flexible rules have costs as well. 

            In 1974, and in the early part of ERISA’s regulatory history, they determined that those latter costs were too high for an enterprise that is attempting to ensure adequate retirement savings for millions of working men and women.  Evolution is a slow process and human nature has not, so far as I can discern, evolved to a more angelic level since 1974, at least in the worlds of finance, investment management, and business.  The judgments made in ERISA’s early days were not, of course, perfect, and we should enjoy the freedom today to adjust them when we are certain that the benefits of adjustment outweigh the costs of adjustment.  But that freedom should be leavened with a heavy responsibility, and the responsibility is to make sure that we know that those benefits outweigh those costs. 

           Making it easier for fiduciaries to engage in cross-trading of the assets of plans that have the ability to protect themselves from the costs of cross-trading is consistent with that responsibility.  Making it easier for ERISA plans to invest in hedge funds, or put another way, weakening the protections that ERISA plans enjoy when they invest in hedge funds, is not consistent with that responsibility.

On May 16, 2005, the SEC issued a Staff Report Concerning Examinations of Select Pension Consultants.

In connection with the SEC report, on June 1, 2005,  DOL and the SEC jointly released tips to help ERISA plan fiduciaries in selecting and monitoring fiduciaries.

The staff report and the jointly released tips focused on whether pension consultants were fully disclosing potential conflicts of interest, particularly where investment consultants' recommendations of money managers to clients might be based on financial incentives from the managers instead of the quality of the managers.

DOL has expressed concern about the difficulty that plan fiduciaries have in discerning the actual costs of services provided to 401(k) plans and has promoted on its WEB site a 401(k) Fee Disclosure Form.

DOL has in its regulatory agenda and in several public venues stated it is working on a section 408(b)(2) regulation update project. Section 408(b)(2) is a primary statutory exemption which allows service providers to provide services to ERISA plans and receive compensation for those services. It seems likely that in the revised regulation under 408(b)(2), DOL will require significant additional disclosure regarding direct and indirect compensation.

On July 21, 2006, DOL a proposed new rule for 5500 disclosure which would require plans to report insurance carriers that fail to provide required information on insurance fees and commissions. In addition, there would be expanded disclosure of direct and indirect service provider fees including revenue sharing.

Apparently, DOL is serious about increased fee disclosure by service providers. This raises some interesting questions:

Ultimately, what kind of disclosures for both 5500 reporting purposes and for compliance with 408(b)(2) will be required?

Assuming greater disclosure, will something positive come of it or will it merely add to the regulatory burden faced by ERISA plans and their service providers?