- Fund Regulation
- Retirement Security
- Trading & Markets
- Fund Governance
- ICI Comment Letters
Department of Labor Hearing on Active Cross-Trades Issues
Investment Company Institute
November 10, 2000
Table of Contents
I. The Process of Cross-Trading
II. The Benefits of Cross-Trades
III. Overly Restrictive Conditions On Cross-Trades Harm ERISA Clients
IV. Institute Recommended Conditions for a Class Exemption for Active Cross-Trades
Good morning. My name is Craig Tyle, General Counsel of the Investment Company Institute1 ("Institute"), the national association of the American mutual fund industry. I appreciate the opportunity to testify at today’s public hearing on active cross-trades issues. The Institute and its members have been actively interested in these issues for many years, having first requested guidance from the Department of Labor (the "Department") on cross-trading in 1983.
The Institute’s consistent position has been that cross-trades provide tangible and significant benefits to mutual funds and other clients of our investment adviser members. Historically, however, pension plans have been denied the benefits associated with cross-trades. We believe that the Department should propose a class exemption to remove this prohibition. Whatever potential abuses related to cross-trades that exist can be fully addressed through imposing appropriate conditions in such a class exemption. In developing such a class exemption, the Department needs to balance its concerns regarding potential risks against the very real benefits that pension plans would realize if they, like other clients of our investment adviser members, could realize the cost savings associated with cross-trades.
My testimony today will address the following four points: general background concerning the process of cross-trading; the benefits associated with cross-trades transactions; how overly restrictive conditions on cross-trades are harmful to ERISA-covered pension plans; and the Institute’s recommended conditions for a class exemption on active cross-trades.
I. The Process of Cross-Trading
In order to put cross-trades in a proper context, it might be helpful to briefly describe the typical trading process at investment advisory firms. Once an investment decision has been made, a separate determination is required—how best to execute that transaction. In making this determination, trading personnel must weigh a variety of factors. These include the cost of the transaction, whether there is likely to be an adverse effect on the price of the security as a result of entering a trade order ("market impact"), and how important it is to complete the transaction quickly.
Depending on the type of security involved, traders will have various alternatives. These can include sending the order to an exchange or market maker, entering the order on an electronic communications network, "bunching" together orders for several client accounts in order to reduce transaction costs, instructing a broker-dealer to "work" the order and sending the order to a particular broker-dealer in accordance with the client’s instructions. Sometimes, when traders receive purchase and sale orders for the same security, they may choose to cross the orders; that is, execute a transaction in which the securities are transferred from one client’s account to the other, without going through a broker or using a broker solely to facilitate the transfer without incurring the usual commission costs.
There are a variety of scenarios in which the opportunity to engage in a cross-trade might arise. Set forth below are a few examples:
Management of Cash Flow. One client of an investment adviser may need to liquidate securities in order to make cash distributions. For example, a mutual fund might have to meet redemption orders. At the same time, another client may have additional assets to invest. If both clients are being managed in accordance with the same basic investment strategy, the securities to be bought and sold may be identical. This situation may arise both with accounts that are "passively" managed in accordance with an index or model, as well as with accounts that are "actively" managed.
Reclassification of Securities. Market developments may change the classification of a security, making it more appropriate for certain accounts and less appropriate for others. For example, a security issued by a growing company that was formerly considered "small capitalization" might be determined to constitute a "mid capitalization" security, or a stock considered a "value" investment might be reclassified as a "growth stock" in response to an increase in the stock’s price. As a result of such reclassifications, the adviser may determine that it is appropriate to adjust its clients’ holding of a particular security. For example, accounts with a "value" focus may want to dispose of the "growth stock," and accounts with a "growth" strategy may wish to acquire it.
Accounts with Different Investment Strategies. Even in the absence of a formal reclassification of a security, there may be reasons why different accounts may be buying or selling the same security. Different clients may be following independent strategies. For example, they may have different portfolio managers or management teams. Under such circumstances, it is possible that the managers of one client will determine it is appropriate to sell a particular security, while another client’s managers will independently determine it is appropriate to buy that security.
II. The Benefits of Cross-Trades
In situations like those mentioned above, why would the trading department of an investment advisory firm conclude that it is in the best interests of the firm’s clients to engage in a cross-trade? The answer is relatively simple: cross-trades provide the opportunity to save both the seller and purchaser of a security substantial transaction costs. In particular, cross-trades can eliminate brokerage commissions on equity securities and dealer mark-ups on debt instruments and other securities generally traded on a principal basis.
Dealer mark-ups and commissions typically range from $.03-$.06 per share on U.S. securities. Because both the buyer and seller pay this amount to execute a transaction on the open market, the total execution cost can range from $.06-$.12 per share. Transaction costs are higher for non-U.S. securities. These transaction costs can be significant when accumulated over multiple trades. Over the long-term, such transaction costs can have a significant impact on the return of an investment portfolio. For example, in a comment letter submitted to the Department in 1998, one of our members estimated that it saved its clients over $300 million annually using cross-trades where appropriate and avoiding such transaction costs.
For these reasons, cross-trading is a fairly common practice among investment advisers. Advisers view cross-trades as providing an important way for them to meet their obligation to provide best execution to their clients. In fact, our members tell us that their non-ERISA clients frequently take an investment adviser’s ability to execute a cross-trade into consideration when determining whether to hire the investment adviser. Many investors thus understand that cross-trades are a valuable tool in investment management.
III. Overly Restrictive Conditions On Cross-Trades Harm ERISA Clients
Notwithstanding the benefits that cross-trading can provide, investment advisers of actively-managed accounts generally have been unable to offer them to their ERISA-covered pension plan clients. This is the case even though the investment adviser adheres to the broad fiduciary standards of ERISA and the cross-trade is prudent and in the best interests of the plan.
The reason for this is that cross-trading is thought to raise issues under ERISA section 406(b)(2), which prohibits a fiduciary from acting in any transaction involving a plan on behalf of a party whose interests are adverse to the interests of the plan. According to the Department, merely representing both sides in a transaction presents an adversity of interests in violation of section 406(b)(2)—even in the absence of imprudence, self-dealing or harm to a plan’s beneficiaries.
The Department has granted a limited number of exemptions to permit cross-trading, subject to various conditions. Especially in the case of investment advisers that follow an active portfolio management strategy, however, these exemptions have proven too restrictive to be of any practical use. This has resulted in virtually all actively-managed ERISA accounts being excluded from participating in cross-trades.
The conditions in these exemptions that are especially problematic are those that require prior independent authorization of each cross-trade and impose price and volume limitations. The requirement to obtain prior independent authorization of each cross-trade from an independent fiduciary, in particular, imposes substantial impediments to conducting a cross-trade for an actively-managed account. There are a number of reasons for this. First, a cross-trading opportunity may disappear during the time it takes for an investment manager to seek and gain the approval of an independent fiduciary to execute the cross-trade, because the other side of the transaction may go forward with the trade. Second, given the fast-paced nature of securities trading, these delays can affect the ability of the trading desk to effectuate the trade under the specific market conditions that led the manager to request the trade. Third, plan sponsor clients, having delegated investment management authority to the manager, do not want, nor have the time, to be involved with approving specific trades. Where such approval is required in a pooled investment vehicle, the problem is compounded because there are multiple fiduciaries that would need to consent to the cross-trade.
The pricing condition for actively-managed individual exemptions is also problematic. The condition imposed by the Department requires that the trading price remain within 10% of the closing price on the day before the manager receives authorization to engage in the cross-trade. In today’s markets, changes exceeding 10% of a security’s price are not uncommon. In fact, such changes may increase the need to execute the trade as soon as possible. The condition, however, imposes an additional delay in order to seek a new authorization.
Under the volume limitation imposed by the Department, the cross-trade must involve less than 5% of the aggregate daily trading volume during the week preceding the trade, unless waived. This level of volume limitation can cause compliance difficulties and prevent plans from participating in various cross-trades transactions.
Thus, broader relief is needed in order to permit ERISA-covered pension plan clients to realize the benefits of cross-trading. The Department clearly has the authority to grant this relief. ERISA section 408 provides the Department with broad authority to exempt classes of transactions from section 406 prohibitions where such relief is (1) administratively feasible; (2) in the interests of the affected plans; and (3) protective of the rights of participants and beneficiaries. Indeed, in the ERISA Conference Report, Congress directed the Department to use the exemption procedure "in order not to disrupt the established business practices of financial institutions which performs [sic] fiduciary functions in connection with these plans consistent with adequate safeguards to protect employee benefit plans."2
The Department, however, has heretofore been concerned that the cost savings offered by cross-trading are outweighed by the risks to plan clients. The Department’s fundamental concern is that granting investment advisers the ability to cross-trade for their ERISA clients will result in some managers abusing this authority by executing cross-trades to benefit one client at the expense of another. Among the potential variations of this scenario that the Department has identified in the past are cross-trades that (1) result in an unfair price to a client, (2) "dump" less favored securities in the account of a client or "cherry pick" attractive securities from that client’s account, and (3) help a favored client avoid the potential market impact of a transaction at the expense of another client.
We do not deny that such abuses are theoretically possible. They are, however, highly speculative and unlikely. Most importantly, irrespective of the existence of a class exemption under Section 406(b)(2), investment advisers have a fiduciary responsibility under ERISA with respect to their investment decisions and in determining how those decisions should be executed.3 The abusive transactions noted above would violate this responsibility. In addition, as discussed further below, the Department can impose conditions in any such class exemption that would provide additional protection in this regard.
IV. Institute Recommended Conditions for a Class Exemption for Active Cross-Trades
As noted above, the Department may wish to impose conditions on investment managers interested in making cross-trading available to their ERISA clients, in order to further guard against any potential abuses. The Institute would support such conditions so long as they are not so onerous that ERISA clients must continue to be uniquely disqualified from realizing the significant benefits that cross-trading can provide.
Of course, the Department has just proposed a class exemption to permit cross-trades involving plan clients whose accounts are passively managed (i.e., in accordance with an index or model). We support the Department’s proposal of such an exemption, although we have concerns with some of the conditions included in the proposal. However, we do not believe that relief in this area should be limited to passively-managed accounts. Plan clients whose accounts are actively-managed also should be permitted to benefit from cross-trading, and the Department should craft an exemption that allows this, while incorporating appropriate safeguards.
In general, we believe that conditions included in a class exemption for active cross-trades should ensure that the following objectives are met:
- The cross-trade provides the anticipated benefits to the clients involved;
- The cross-trade takes place at a fair price that does not favor one client over another;
- Consistent with the investment adviser’s fiduciary responsibilities, any transaction involving a cross-trade is in the best interests of the client; and
- There is full disclosure to the client regarding cross-trades.
We describe below suggested specific conditions that would fulfill each of these objectives. It is important to note that conditions such as these are already imposed on mutual funds that engage in cross-trades pursuant to a rule under the Investment Company Act. We understand that the Department does not believe that it should necessarily be bound by that standard. Nonetheless, we urge the Department to take account of the fact that this approach has proved to be highly successful. It has allowed mutual funds to realize the benefits of cross-trading, and there is no evidence that this has resulted in any of the abuses identified by the Department.4
A. The Cross-Trade Provides the Anticipated Benefits to the Clients Involved.
First, a class exemption should ensure that no commission or brokerage fee is paid in connection with the transaction (other than customary transfer fees). This provision ensures that both the buyer and seller benefit from the cost savings associated with cross-trades and that there is no direct benefit to the investment adviser. The Department has imposed a similar condition in its individual exemptions as well as in its proposed class exemption for cross-trades involving passively-managed accounts.
B. The Cross-Trade Takes Place at a Fair Price That Does Not Favor One Client Over Another.
A second objective of any class exemption should be to ensure that all cross-trades take place at a fair price. This will prevent what is perhaps the most obvious potential abuse—that one client will pay too much or receive too little in a cross-trade in order to benefit another client.
Accordingly, one condition that should be included in a class exemption is a requirement that the transaction be effected at a current market price in accordance with specific and objective methodologies. Requiring that all cross-trades take place at an objectively-determined price in this manner will guard against this potential abuse. As we have previously commented, we believe that use of a "current" price for these purposes is preferable to a "closing price" (which is the standard included in the proposed class exemption for passively-managed accounts), because this will permit the trade to occur under the market conditions that gave rise to the purchase and sale decisions. Equally important is the need for there to be consistency between any standards adopted by the Department and by the SEC. We urge the Department and the SEC to work together to come up with a common approach in this area.
A second condition, and one which follows from the first, is one that requires that any security that is the subject of a cross-trade transaction be one for which market quotations are readily available. This would help ensure that any prices used to determine the appropriate price for the cross-trade are true independent market prices. It also would exclude illiquid securities, and thus minimize the potential for cross-trades being used to "dump" securities that are difficult to sell in another client’s account. In addition, transactions in liquid securities are less likely to involve significant market impact costs.
C. Consistent With The Investment Adviser’s Fiduciary Responsibilities, Any Transaction Involving a Cross-Trade Is In The Best Interests of the Client.
A third objective would be to respond to the potential risk of an adviser causing its client to engage in a transaction in order to benefit another client.5 Of course, the requirement to use an objective price would minimize the risk, as it eliminates the most obvious reason why such a transaction would be made. Nonetheless, the Department has expressed concerns that the potential risk still exists, particularly if an adviser wishes to avoid any market impact resulting from sending an order to the market.
As a preliminary matter, we wish to note that this concern does not arise in the case of passively-managed accounts. If transactions are the result solely of external events (e.g., changes to an index, cash inflows and outflows model-driven reallocation), they cannot be said to have been influenced by the desire to benefit another client.
In the case of actively-managed accounts, because transactions are not solely the result of external events, it would be appropriate to adopt additional conditions that would give greater protection. It should be remembered, however, that in addition to these conditions, the investment adviser would remain subject to the fiduciary standards under federal law, including ERISA. Engaging in a transaction involving one client in order to benefit another client would violate those standards, even if they complied with a class exemption under Section 406(b)(2).
There are two types of conditions that the Institute believes would provide the requisite degree of additional protection for active cross-trades. One would be an express requirement that any transaction that is the subject of a cross-trade be consistent with the investment objectives and policies of the plan. In effect, this provision would ensure that any such transaction reflects the investment strategy of the plan, and is not occurring in order to benefit some other client.
The second type of condition would involve disclosure and recordkeeping of cross-trades. Requiring disclosure of all cross-trades to plan fiduciaries would enable them to determine if any of the transactions were problematic or at least to make further inquiries of the adviser. It also would act as a significant disincentive to an investment adviser that was considering cross-trades not in the plan’s best interests. As Justice Brandeis noted, "Sunlight is the best disinfectant."
Accordingly, we believe the Department should require that all plans be provided with detailed quarterly reports on all cross-trades executed on behalf of the plans. These reports should provide information regarding each cross-trade transaction, including relevant price information.
In addition, the Department should include recordkeeping requirements similar to those proposed in Department’s proposed class exemption for passive cross-trades.6 These include that the investment adviser hold for 6 years from the date of each cross-trade records that identify: (1) the securities bought and sold as a result of cross-trades; (2) how much of each security; and (3) pricing information. We believe these conditions would effectively guard against the types of abusive transactions that the Department has identified, including transactions designed to avoid market impact costs.7
We believe that these conditions—together with the fiduciary standards of ERISA—would give adequate assurance against cross-trades being conducted in order to benefit one client at the expense of another. As a consequence, we do not believe that there are any remaining issues related to the effect of market impact costs. As we have stated previously, where two clients engage in offsetting transactions for reasons independent of any cross-trading potential and where each of these transactions would have a market impact, the fairest thing to do, at least in general, would be to cross the trades—thereby saving the transaction costs and avoiding disadvantaging either client.8
D. Initial Disclosure to the Client and Prior Authorization Regarding Cross-Trades.
A fourth objective would be to ensure that all ERISA clients receive full and adequate disclosure concerning the cross-trades procedures and protections. (This disclosure would be in addition to the quarterly reports noted above.) In particular, we recommend that plan fiduciaries receive, prior to authorization of the plan’s participation in a cross-trades program, a notice describing the cross-trading program’s policy and procedures, and applicable safeguards. In addition, we believe that such notice should include disclosure concerning the potential benefits and risks of cross-trade transactions. Such a notice, we believe, would provide an independent plan fiduciary with full and adequate disclosure to aid the fiduciary in balancing the potential benefits of entering into a cross-trades program against the related concerns. In addition, we recommend requiring investment managers to provide their ERISA clients with an annual notice reminding clients of the option to terminate and the investment adviser’s termination procedures.
As a related matter, and in order to ensure that the plan sponsor has the requisite sophistication and expertise to evaluate this disclosure, as well as that included in the periodic reports, the Institute would support a condition limiting the availability of cross-trades to large plans (i.e., those with over $25 million in assets). Smaller plans could be permitted to participate if they retained an independent fiduciary for these purposes. In addition, special conditions would need to be adopted for collective investment funds and other pooled arrangements, which can include plan investors with both large and small asset sizes.
We believe that a class exemption for active cross-trades that includes the above mentioned conditions would fully protect the interests of retirement plans, and their participants and beneficiaries. Indeed, it would enhance their interests by permitting them to take advantage of opportunities that other clients enjoy. When conducted with appropriate safeguards, we believe that cross-trades transactions occurring between two managed accounts are clearly in the best interest of both clients, because they eliminate unnecessary and often substantial transaction costs.
The Institute appreciates the ability to opportunity to express its views on this very important matter. We would look forward to working with Department staff on an active cross-trades class exemption or to further discuss any of the issues I have raised at today’s hearing.
1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes 8,018 open-end investment companies ("mutual funds"), 495 closed-end investment companies, and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $6.802 trillion, accounting for approximately 95% of total industry assets, and over 78.7 million individual shareholders.
2 H.R. Conf. Rep. No. 1280, 93rd Cong., 2d Sess. 309 (1974).
3 Investment managers that exercise investment discretion over the assets of a plan are fiduciaries subject to the fiduciary responsibility rules set forth in Title I, Part 4 of ERISA. ERISA section 3(21)(A)(i). As such, they must act solely in the interests of the participants and beneficiaries of the plan, for the exclusive purposes of providing benefits to them and defraying reasonable expenses of administering the plan. They are also required to act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. Finally, managers are prohibited from dealing with plan assets in their own interests or for their own account. ERISA sections 403(c)(1), 404(a)(1), 404(a)(1)(A), 404(a)(1)(B) and 406(b)(1). Registered investment advisers are also subject to the fiduciary standards imposed under the Investment Advisers Act. Securities and Exchange Commission v. Capital Gains Research Bureau, 375 U.S. 180 (1963).
4 We further note the importance of ensuring that investment advisers who are subject to both the federal securities laws and ERISA are not being subjected to inconsistent regulatory standards.
5 In order to avoid the potential of transactions that would benefit the adviser directly at the expense of the client, we would support a condition that would exclude proprietary accounts from the scope of the exemption.
6 See 64 Fed. Reg. 70057 (Dec. 15, 1999).
7 The Department also may wish to include a condition requiring advisers to adopt procedures to ensure the fair allocation of any cross-trading opportunities. A similar condition is included in the proposed class exemption for passively managed accounts.
8 Moreover, whether a trade will have market impact and, if so, the extent of such impact, will often be uncertain. In contrast, cross-trading will result in a definite savings from the avoidance of transaction costs that will benefit both clients.