Prepared Testimony of
Henry H. Hopkins
Chief Counsel and Vice President
T. Rowe Price Group, Inc.

Presented at the
ERISA Advisory Council's Hearing on
Actively Managed Cross-Trade Transactions

September 20, 2006

Good morning. My name is Henry Hopkins. I am Chief Counsel and Vice President of T. Rowe Price Group, Inc. On behalf of T. Rowe Price, thank you for the opportunity to participate in the ERISA Advisory Council's public hearing relating to the regulation of cross-trade transactions involving actively-managed accounts subject to the requirements of ERISA.¹ We congratulate the Council for recognizing the significance of this issue for ERISA-covered investors and appreciate the opportunity to express our views.

Although most notable for its family of more than 95 open-end registered investment companies, T. Rowe Price also has advisory relationships with approximately 404 institutional and individual discretionary account clients representing assets of over $94 billion. Thus, as a registered investment adviser to mutual funds and private accounts with assets under management of approximately $293.7 billion, T. Rowe Price has a significant interest in this matter.

In addition to T. Rowe Price, I am here today representing the Investment Adviser Association and the Investment Company Institute. The Investment Adviser Association ("IAA") is a not-for-profit organization that represents federally registered investment advisory firms. Founded in 1937, the IAA's membership consists of about 450 firms that collectively manage in excess of $6 trillion for a wide variety of individual and institutional clients. The Investment Company Institute ("ICI") is the national association of the American investment company industry. Many of the ICI's 580 investment adviser members render investment advice to both investment companies and other clients. In addition, the ICI's membership includes 171 associate members, which render investment management services exclusively to non-investment company clients. A substantial portion of the total assets managed by registered investment advisers is managed by these ICI members and associate members. The IAA, the ICI, and their members have been actively involved in discussions regarding relief for cross trades under ERISA for many years.

With me today on behalf of the IAA and ICI are Scott Lopez, Director of Global Equity Trading, Wellington Management, and Mary McDermott-Holland, Head Trader, Franklin Portfolio Associates, LLC.

Also with us is William A. Schmidt, Kirkpatrick & Lockhart Nicholson Graham, LLP, who represents a number of plan sponsors and trade organizations that represent plans.

The ICI and IAA have assembled this panel to provide you with information regarding cross-trading for actively-managed accounts. We also look forward to answering any questions the Council may have, but would encourage you to wait until the completion of the panelists' statements so that you have the benefit of testimony from the entire panel before asking your questions.

Table of Contents

A. The Act's Conditions

1. Pricing Mechanism
2. Established Procedures
3. Client Approval
4. Reporting and Recordkeeping

B. The Act's Sophistication Test

1. Pooled Funds
2. Use of Sophisticated Consultants

I. Introduction
Together with the IAA and the ICI membership, T. Rowe Price has for more than 30 years been actively involved in encouraging the adoption of an exemption from the prohibited transaction rules to permit cross-trade transactions involving actively-managed accounts subject to the requirements of ERISA because it believes that such relief is essential to ensuring that ERISA-covered investors are offered the same opportunities for reducing transaction costs arising in connection with the purchase or sale of securities that are available to non-ERISA investors.

T. Rowe Price and the IAA and ICI membership have a strong interest in expanding exemptive relief for these transactions because our clients look to us to maximize the net returns on their invested capital. The potential for cost savings is obvious. When a trade is executed on behalf of a client on the open market, the dealer mark-ups and commissions typically range from $.03-.06 per share. Both the buyer and seller pay this amount, so the total execution cost can range from $.06-.12 per share. Thus, the commission cost associated with a transaction involving 1,000 shares of stock can range from $60-$120. Over the course of a year, these accumulated commissions can represent a significant cost to a retirement plan. According to a report issued to the ERISA Advisory Council, by Thomas H. McInish, Ph.D., C.F.A., in July of 2002, trading costs also include indirect costs such as the bid-ask spread and market impact costs as well as the opportunity costs of missing a trade. Professor McInish concludes that the "benefits of cross trading are clear and substantial."²

Evidence of the potential cost savings also comes from investment advisory firms that have been issued individual exemptions by the Department of Labor (the "Department"). Several institutions have previously advised the Department of cost savings in the range of $300 million a year through their cross-trading programs.³ Similar reports of substantial savings have been made to the Department by plans that have participated in such cost savings.⁴

II. Pension Protection Act
In the recently enacted Pension Protection Act (H.R. 4) (the "Act"), Congress implicitly recognized the benefits of cross trading when it issued an exemption providing retirement plans the option of participating in cross-trading opportunities that had previously not been available for their actively-managed accounts. Significantly, the exemption applies only to actively-managed retirement plans that affirmatively agree through their independent fiduciaries to participate in cross-trading activities pursuant to procedures setting forth a clear understanding under which the cross trades will be processed.

T. Rowe Price applauds Congress' efforts and, in particular, its decision to use SEC Rule 17a-7 under the Investment Company Act of 1940 (originally adopted in 1966) as the framework for enacting workable exemptive relief for cross-trade transactions. Rule 17a-7has proven to be an effective means of ensuring that cross-trades are made in the best interests of both clients involved in the transaction for over 40 years. Moreover, the Act's use of Rule 17a-7 as the framework for exemptive relief promotes regulatory consistency and thereby helps to provide ERISA-covered investors with all the advantages that non-ERISA investors have in ensuring that their securities trades are made at the lowest incremental cost. Consistent rules are appropriate because the Department and the SEC share the same underlying policy concerns regarding cross-trade transactions. Both the Department and the SEC seek to ensure that a fiduciary fulfills its duties to its clients by promoting cost savings and market efficiencies while at the same time ensuring that the interests of such clients are fully protected.

A. The Act's Conditions
The Act sets forth a comprehensive package of pricing, disclosure, consent, and reporting conditions for engaging in cross trades on behalf of actively managed accounts. Before describing the Act's cross-trade provisions in greater detail, I thought it would be helpful to briefly describe the typical investment and trading process at investment advisory firms under Rule 17a-7 in order to put cross-trade transactions in a proper context.

For actively managed accounts, it is only after the investment decision is made that the determination of the best way to execute the decision presents itself. While an account or portfolio manager might place certain conditions on a transaction, such as a maximum price or minimum quantity on a purchase order, the investment decision is not made on the basis of a particular trading strategy - for example, the ability to buy or sell the security through a cross trade. Rather, it is typically the trading department's responsibility to determine how to execute that transaction on the basis of what is in the best interests of the account on whose behalf the transaction is being made.

In making this decision, traders must weigh a variety of factors, which will be discussed in detail by Scott Lopez and Mary McDermott-Holland during their presentations. As they will point out, among other things, the factors for consideration include the cost of the transaction and whether there is likely to be an adverse effect on the price of the security as a result of entering a trade order. Moreover, depending on the type of security involved, traders will have various alternatives in effecting the trade - only one of which is to cross the trade.

In order to ensure that the decision and implementation of a cross trade is made in compliance with Rule 17a-7, investment advisory firms have developed procedures pursuant to which a cross-trade opportunity is carried out and documented. Such procedures require the trader to complete a due diligence process regarding prospective cross trades, which is intended to confirm compliance with client-imposed restrictions as well as the requirements of Rule 17a-7, as applicable. The trader also confirms reasonable expectations that the trade would not have any market impact that would disadvantage either account.⁵

We believe that the conditions required by the Act include the fundamental elements of Rule 17a-7 that are reflective of the realities and structure under which securities trades are made for managed accounts, but with certain modifications necessary to account for the unique circumstances and ensure the protection of retirement plan investors.

1. Pricing Mechanism
Most importantly, the Act requires covered transactions to be effected at "current market price"⁶ of the security determined in accordance with Rule 17a-7 which has as its fundamental principle the concept that the subject securities be priced on an independent basis.⁷

There are three principal advantages to using this standard. First, the method for determining "current market price" under Rule 17a-7 is intended to be completely beyond the control of the account or portfolio manager. The intent behind the Rule is to ensure that managers cannot exercise discretion in pricing transactions for the benefit of either side of the transaction. Second, Rule 17a-7 provides a pricing structure that is more reflective of the most recent market activity with respect to the subject security. In this respect, as to be discussed by Scott and Mary in their presentations, we believe that the use of the security's "closing price" creates the potential for opportunity cost to be associated with the cross trade. Finally, and perhaps most importantly, a consistent and compatible pricing structure for ERISA and non-ERISA accounts is of paramount importance to the usefulness of the relief granted by the Act.

Additionally, like Rule 17a-7, the Act provides that no brokerage commissions, fees (except for customary transfer fees), or other remuneration would be paid in connection with a cross-trade transaction.

2. Established Procedures
The Act also mandates that investment managers adopt and effect cross trades in accordance with written cross-trading policies and procedures that are fair and equitable to all accounts participating in the cross-trading program and that include a description of the manager's pricing policies and procedures, and the manager's policies and procedures for allocating cross trades in an objective manner among accounts participating in the cross-trading program. This requirement is derived from provisions of Rule 17a-7, which requires the board of directors of the investment company to adopt procedures designed to ensure compliance with conditions of the Rule and to review the transactions quarterly to ensure that all such purchases or sales made during the preceding quarter were affected in compliance with these procedures.

The Department has been instructed by Congress, after consultation with the SEC, to issue regulations regarding the content of policies and procedures required to be adopted by an account manager under the requirements for the exemption. Clearly, the intent of Congress is for the Department to work with the SEC in crafting the requirements for such policies and procedures in a manner which ensures that they are consistent with SEC Rule 17a-7. Given the 40 years of experience that investment management firms have in processing cross trades in accordance with internal procedures designed to comply with Rule 17a-7 and other applicable law, we urge the Council to recommend that the Department's regulations continue to allow managers to develop policies and procedures that will be most effective in their organizations and will not constrain their ability to ensure that ERISA-covered investors are allocated the same opportunities for reducing transaction costs through cross trades that are available to non-ERISA investors.

3. Client Approval
Another significant concern addressed in the Act is the method by which clients would agree to participate in the cross-trade program of an investment manager. In this respect, the Act contains specific rules by which plan clients must affirmatively approve participating in or opting out of the investment manager's cross-trade program. More specifically, the Act requires that afiduciary for each plan, which is independent from the investment manager, authorize, in a document that is separate from any other written agreement of the parties, the investment manager to engage in cross trades at the investment manager's discretion. Moreover, such authorization can only be given after the independent fiduciary has been provided disclosure regarding the conditions under which cross trades may take place, including the written policies and procedures of the investment manager. Such disclosure must be separate from any other agreement or disclosure involved in the asset management relationship.

4. Reporting and Recordkeeping
The Act also sets forth a comprehensive list of reporting and disclosure requirements together with a review and certification obligation on the part of the investment manager. Specifically:

B. The Act's Sophistication Test
Finally, while T. Rowe Price strongly believes that the pricing standards of Rule 17a-7, combined with the client approval and reporting rules identified above, are sufficient on their own to protect clients from potential self-dealing by their investment managers effecting cross trades on their behalf, we note that the Act also limits participation in cross-trading programs to only the very largest plans, namely those with at least $100 million in assets. The intent of this condition is presumably to ensure that plans participating in a cross-trade program have sufficient financial sophistication to evaluate the periodic reports described earlier. While we appreciate and agree with Congress' desire to ensure that plan fiduciaries have the level of sophistication necessary to monitor the cross-trade transactions executed on behalf of their plan, a $100 million threshold prevents all but the largest 3.9 percent of defined benefit plans from being able to benefit from the ability to increase incremental returns on their capital through cross-trading programs.⁹ We are concerned that limiting the benefits of cross-trading opportunities to plans with $100 million in assets unnecessarily restricts most plans from sharing in the incremental returns that cross trading makes available.

While we believe that the Act's $100 million threshold for participating in cross-trade opportunities is unnecessary, in the event the Council is of the position that some "sophistication" standard is essential, we recommend developing additional sophistication tests that will allow a greater percentage of plans to benefit from cross-trade opportunities, while at the same time ensuring that the interests of such plans are protected. Set forth below are two illustrative examples:

1. Pooled Funds
One potential way of extending the benefits of the exemption to a broader range of plans is to provide exemptive relief for pooled funds, such as common trust funds, whose assets are also considered to be covered by the requirements of ERISA. For such pooled funds, participation in a cross-trade program could be conditioned on at least one plan investing in the pooled fund having total assets of a certain threshold, such as $100 million in total assets. This condition would ensure that at least one plan participating in a pooled fund with a cross-trade program would be considered to have sufficient financial expertise to evaluate the periodic reports that the investment manager is required to provide pursuant to the Act. Because all cross trades made on behalf of the pooled fund would impact all plan investors in the same way but on a pro rata basis, an investor in the pooled fund that did not meet the requisite asset threshold size would benefit from the fact that at least one such investor is considered to have the requisite financial sophistication.

All of the other conditions required by the Act would also apply with regard to investment in the pooled fund. For example, in the case of plans participating in a pooled fund prior to the decision of the investment manager to institute the cross-trade program for the pooled fund, a copy of the investment manager's policies and procedures would be sent to an independent fiduciary of each participating plan together with a notice advising the fiduciary that the manager intends to effect cross-trade transactions on behalf of the pooled fund pursuant to the adopted procedures. The notification would also indicate that the plan would have the opportunity to withdraw from the pooled fund without penalty prior to the initiation of the cross-trade program. In the case of the plan which decides to invest in a pooled fund for which a cross-trade program has previously been instituted, as required under the Act, a description of the cross-trade program and its policies and procedures would be required to be delivered to the independent fiduciary prior to the investment of plan assets in the pooled fund.

2. Use of Sophisticated Consultants
While Congress has determined that the Act's cross-trade exemption should be limited to plans whose asset size meets a particular threshold to ensure that the plan sponsor has the requisite sophistication and expertise to engage in a cross-trade program, such a bright line test fails to recognize that plan sponsors may also have other resources available to assist them in fulfilling their duties. To our knowledge, the Department has never identified a type of investment that was per se inappropriate for a plan investor. The Department has, however, recognized that certain types of plan investments may require a greater degree of sophistication on the part of plan fiduciaries. For example, in a letter describing fiduciary guidelines for the investment of plan assets in derivatives, the Department indicated that certain plan investments "may required a higher degree of sophistication and understanding on the part of plan fiduciaries than other investments."¹⁰

In those cases where plan fiduciaries do not have the requisite sophistication on their own, the Department has encouraged plan fiduciaries to retain consultants and other experts to help them assess the appropriateness of a particular investment for the plan's portfolio. This position recognizes that, even though a plan fiduciary might not have the requisite sophistication to review the appropriateness of a particular investment on its own, the plan fiduciary acting with appropriate guidance and expertise provided by those who do have such sophistication should not be precluded from investing in a particular investment on behalf of the plan. Similarly, so long as a plan's participation in a cross-trade program is reviewed by a party who is unrelated to the investment manager engaging in the cross trade, and who is considered to have the necessary sophistication to properly evaluate the plan's participation in a cross-trade program, the plan should not be precluded from the opportunity to increase its incremental returns on its capital through participation in a cross-trading program that otherwise meets the requirements of the Act.

* * *

In summary, together with the IAA and the ICI membership, T. Rowe Price applauds Congress' adoption of exemptive relief for cross-trade transactions involving actively managed ERISA-covered accounts. The cross-trade provision included in the Act is comprehensive in its inclusion of conditions intended to protect the interests of plan investors. At the same time, we believe that Congress' use of Rule 17a-7 pricing standards shows that it understood that regulatory consistency is essential to the development of workable exemptive relief for cross-trade transactions. Without consistency of regulation with respect to the processing of cross trades, investment managers will be unable to provide their ERISA-covered clients with the transactional cost relief available to non-ERISA investors. We urge the Council to recommend to the Department that the need for such regulatory consistency is fundamental to any approach taken by the Department in proposing regulations regarding the content of policies and procedures to be adopted by investment managers who intend to make available cross-trade opportunities to ERISA-covered accounts. We also urge the Council to recommend the adoption of this panel's recommendations or propose other similar exemptive relief for allowing a greater percentage of plans to benefit from the ability to increase their incremental returns through cross-trading opportunities.

1 Employee Retirement Income Security Act of 1974 (ERISA)

2 See Final Report:  "Cross-Trading by ERISA Plan Managers," Thomas H. McInish, Ph.D., C.F.A. (July, 2002).

3 Barclays Global Investors in San Francisco advised PWBA in a comment letter that it saves $300 million a year through cross trading on $485 billion in assets managed for U.S. clients.  See May 18, 1998 letter from Joanne T. Medero, Managing Director and Chief Counsel, Barclays Global Investors, to PWBA. State Street Bank and Trust Co. similarly saves clients over $300 million each year through cross trades.  Morgan Stanley Asset Management, Inc. advised PWBA of similar cost savings.

4 In a letter sent by the in-house administrator of two plans maintained by Exxon, the PWBA was advised that the estimated savings to one of the plans resulting from cross trading was approximately 9 percent of total transaction costs or more than $1 million over a two-year period.  See May 18, 1998 letter from Edgar A. Robinson, Administrator - Finance, Annuity plan of Exxon Corporation and Participating Affiliates, to PWBA.  See also "Losing the Middleman:  Why the Methodist 403(b) plan insists on a manager with internal crossing capability."  Plan Sponsor, March 1998.

5 In addition to legal restrictions imposed by the 1940 Act, cross trading by investment advisers is subject to the provisions of Section 206 of the Investment Advisers Act of 1940, which apply even if the conditions of Rule 17a-7 were satisfied.  Section 206 was enacted to prevent transactions which defraud, or operate as a fraud or deceit upon, clients, or prospective clients.  In addition to the specific prohibitions of Section 206, the Supreme Court in Transamerica Mortgage Advisors, Inc., et al. v. Lewis stated that Section 206 establishes a statutory fiduciary duty for investment advisers to act for the benefit of their clients.  The SEC has indicated that certain specific obligations flow from this fiduciary duty, including a duty: (1) to have a reasonable, independent basis for its investment advice; (2) to obtain best execution for clients' securities transactions where the adviser is in a position to direct brokerage transactions; (3) to ensure that its investments on behalf of clients are suitable to the client's objectives, needs, and circumstances; and (4) to be loyal to each of its clients.  Thomas P. Lemke and Gerald T. Lins. Regulation of Investment Advisers, pgs. 2-36 and 2-37 (1998 ed.).

6 In the case of "reported securities," "current market price" is defined as the last sale price reported in the consolidated transaction reporting system, or, if no transactions have been reported on that day, the average of the highest current independent bid and lowest current independent offer for such security.  For securities traded primarily on an exchange that are not reported securities, the "current market price" is the average of the highest current independent bid and lowest current independent offer on such exchange if there are no reported transactions on such exchange that day.  In the case of securities that are not reported securities and are not principally traded on an exchange but are quoted in the NASDAQ system, "current market price" is the average of the highest current independent bid and lowest current independent offer reported on Level 1 of NASDAQ.  Finally, "current market price" for all other securities is the average of the highest current independent bid and lowest current independent offer determined on the basis of reasonable inquiry.  17 CFR 270.17a-7(b)(1)-(4).

7 The background of Section 17(a) and Rule 17a-7, and the rationale behind the current version of Rule 17a-7 are discussed thoroughly in Investment Company Act Release No. 11136 (April 21, 1980) 45 FR 29067, May 1, 1980 ("Release No. 11136").

8 Confidentiality constraints could limit the identification of the parties involved in the cross trade to the type and nature of the counterparty to the transaction in some cases, e.g., where counterparty is a separate account.

9 Private Pension Plan Bulletin, Abstract of 2001 Form 5500 Annual Reports, U.S. Dept. of Labor, EBSA, February, 2006.

10 See letter from Olena Berg, Assistant Secretary Pension and Welfare Benefits Administration, U.S. Department of Labor to Eugene Ludwig, Comptroller of Treasury (March 21, 1996).