[Federal Register Volume 63, Number 54 (Friday, March 20, 1998)]
[Notices]
[Pages 13696-13701]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-7271]


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DEPARTMENT OF LABOR

Pension and Welfare Benefits Administration


Cross-Trades of Securities by Investment Managers

AGENCY: Pension and Welfare Benefits Administration, Labor.

ACTION: Notice.

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SUMMARY: This document announces that the Department has under 
consideration certain applications for exemptions relating to cross-
trades of securities by investment managers with respect to any 
account, portfolio or fund holding ``plan assets'' 1 subject 
to the fiduciary responsibility provisions of Part 4 of Title I of the 
Employee Retirement Income Security Act of 1974, as amended (ERISA). 
The Department requests information to assist it in determining upon 
what standards and safeguards exemptive relief should be conditioned.
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    \1\ See 29 CFR 2510.3-101, Definition of ``plan assets''--plan 
investments.
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DATES: Responses must be received on or before May 19, 1998.

ADDRESSES: Responses (preferably, at least three copies) should be 
addressed to: Pension and Welfare Benefits Administration, Office of 
Exemption Determinations, Room N-5649, 200 Constitution Ave., NW., 
Washington, DC 20210. Attention: ``Cross-Trades of Securities''.

FOR FURTHER INFORMATION CONTACT: Louis J. Campagna or E.F. Williams, 
Office of Exemption Determinations, Pension and Welfare Benefits 
Administration, U.S. Department of Labor, 200 Constitution Avenue, NW., 
Washington, DC 20210, (202) 219-8883 or 219-8194 (not toll-free 
numbers); or Michael Schloss, Plan Benefits Security Division, Office 
of the Solicitor, (202) 219-4600 ext. 138 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

A. Background

    There are generally two types of securities cross-trading 
transactions: (i) Direct cross-trades, and (ii) brokered cross-trades.
    Direct cross-trades occur whenever an investment manager causes the 
purchase and sale of a particular security to be made directly between 
two or more accounts under its management without a broker acting as 
intermediary. Under this practice, the manager executes a securities 
transaction between its managed accounts without going into the ``open 
market''--such as a national securities exchange (e.g., the New York 
Stock Exchange (``NYSE'') or an automated broker-dealer quotation 
system (e.g., the National Association of Securities Dealers Automated 
Quotation National Market System (``NASDAQ'').
    Brokered cross-trades occur whenever an investment manager places 
simultaneous purchase and sale orders for the same security with an 
independent broker-dealer under an arrangement whereby such broker-
dealer's normal commission costs are reduced. In such instances, 
brokers are often willing to accept a lower commission because the 
transaction will be easier to execute where there are shares already 
available to complete the order for both the buyer and the 
seller.2
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    \2\ This notice assumes that cross-trades, including brokered 
cross-trades, are not performed on the market as ``wash sales'' (in 
which the same party is the buyer and seller) or as ``matched 
orders'' (in which confederates simultaneously enter offsetting 
purchase and sale orders). These and similar types of trades may be 
used to manipulate stock prices and may raise other issues under 
ERISA.
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    Cross-trading transactions could result in violations of one or 
more provisions of Part 4 of Title I of ERISA. Section 406(b)(2) 
provides that an ERISA fiduciary may not act in any transaction 
involving a plan on behalf of a party (or represent a party) whose 
interests are adverse to the interests of the plan or the interests of 
its participants or beneficiaries. Where an investment manager has 
investment discretion with respect to both sides of a cross-trade of 
securities and at least one side is an employee benefit plan account, 
the Department has previously taken the position that a violation of 
section 406(b)(2) of ERISA would occur.3 The Department has 
also taken the position that by representing the buyer on one side and 
the seller on the other in a cross-trade, a fiduciary acts on behalf of 
parties that have adverse interests to each other.4 
Moreover, the prohibitions embodied in section 406(b)(2) of ERISA are 
per se in nature. Merely representing both sides of a transaction 
presents an adversity of interests that violates section 406(b)(2) even 
absent fiduciary misconduct reflecting harm to a plan's 
beneficiaries.5
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    \3\ Reich v. Strong Capital Management Inc., No. 96-C-0669, USDC 
E.D. Wis. (June 6, 1996).
    \4\ See Strong Capital Management Inc., supra.
    \5\ See, Cutaiar v. Marshall, 590 F.2d 523 (3d Cir. 1979). In 
Cutaiar, the court held that, ``* * * when identical trustees of two 
employee benefit plans whose participants and beneficiaries are not 
identical effect a loan between the plans without a section 408 
exemption, a per se violation of ERISA exists.'' Cutaiar, 590 F.2d 
at 529.
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    In addition, violations of section 403 and 404 could also arise 
where the investment manager represents both sides in a cross-trade. 
Section 404(a)(1)(A) of ERISA requires, in part, that a plan fiduciary 
must discharge its duties solely in the interests of the participants 
and beneficiaries of that plan and ``for the exclusive purpose'' of 
providing benefits to participants and beneficiaries and defraying 
reasonable plan expenses. Similarly, section 403(c)(1) of ERISA 
requires, in part, that the assets of a plan must be ``* * *held for 
the exclusive purposes of providing benefits to participants in the 
plan and their beneficiaries and defraying reasonable expenses of 
administering the plan.''
    The Department has granted a number of individual exemptions from 
the prohibitions of section 406(b)(2) of ERISA for cross-trades of 
securities by investment managers on behalf of employee benefit plan 
accounts or pooled funds which contain ``plan assets'' subject to 
ERISA.6 These individual exemptions generally have focused 
on direct cross-trading transactions. The individual exemptions granted 
have not provided relief for any violations of section 406(b)(1) or 
(b)(3) of the Act 7 which may occur as a result

[[Page 13697]]

of cross-trades where an investment manager has discretion for both 
sides of the trade. In this regard, the Department notes that the 
individual exemptions cannot provide exemptive relief for such managers 
from the provisions contained in sections 403 and 404. Thus, even when 
proceeding under an individual exemption, an investment manager remains 
fully liable under sections 403 and 404 of ERISA for the investment 
decision relating to a cross-trade.
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    \6\ In this regard, see the following Prohibited Transaction 
Exemptions (PTEs): PTE 95-83, Mercury Asset Management (60 FR 47610, 
September 13, 1995); PTE 95-66, BlackRock Financial Management L.P., 
(60 FR 39012, July 31, 1995); PTE 95-56, Mellon Bank, N.A. (60 FR 
35933, July 12, 1995); PTE 94-61, Batterymarch Financial Management 
(59 FR 42309, August 17, 1994); PTE 94-47, Bank of America National 
Trust and Savings Association (59 FR 32021, June 21, 1994); PTE 94-
43, Fidelity Management Trust Company (59 FR 30041, June 10, 1994); 
PTE 94-36, The Northern Trust Company (59 FR 19249, April 22, 1994); 
PTE 92-11, Wells Fargo Bank, N.A. (57 FR 7801, March 4, 1992)--which 
replaced PTE 87-51 noted below; PTE 89-116, Capital Guardian Trust 
Company (54 FR 53397, December 28, 1989); PTE 89-9, State Street 
Bank and Trust Company (54 FR 8018, February 24, 1989); PTE 87-51, 
Wells Fargo Bank, N.A. (52 FR 22558, June 12, 1987); and PTE 82-133, 
Chase Manhattan Bank, N.A. (47 FR 35375, August 13, 1982).
    \7\ Section 406(b)(1) of ERISA prohibits a plan fiduciary from 
dealing with the assets of the plan in his own interest or for his 
own account. Section 406(b)(3) prohibits a plan fiduciary from 
receiving any consideration for his own personal account from any 
party dealing with such plan in connection with a transaction 
involving the assets of the plan.
    The Department notes that some of the individual exemptions have 
provided, and some of the current exemption applications also 
request, relief from the prohibitions of section 406(a)(1)(A) of 
ERISA. Section 406(a)(1)(A) states, in pertinent part, that a 
fiduciary of a plan shall not cause the plan to engage in a 
transaction which constitutes a sale, exchange, or leasing of any 
property between the plan and a party in interest. Relief from this 
section was provided in certain of the cross-trading exemptions in 
response to the applicants' representations that some plans may be 
parties in interest to other plans participating in the cross-
trading program.
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    The Department has also granted a class exemption which provides 
relief for, among other things, certain agency cross-trades of 
securities where an investment manager has discretion for, and/or 
provides investment advice to, either the seller or the buyer, but not 
both, or where the investment manager does not have discretion for, 
and/or provide investment advice to, any plan involved in the 
transaction (see PTE 86-128 (51 FR 41686, November 18, 1986)). Such 
cross-trades do not require individual exemptive relief if the 
conditions of PTE 86-128 are met.
    The Department currently has under consideration a number of 
individual exemption applications which request relief for cross-
trading programs that involve purchases and sales of securities by 
employee benefit plans.8
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    \8\ These exemption requests include the following: D-9584, 
Wells Fargo Bank, N.A.; D-10107, Bankers Trust Company of New York; 
D-10210 and D-10211, Rowe Price Fleming International, Inc., and T. 
Rowe Price Associates, Inc.; D-10290, State Street Bank and Trust 
Company; D-10322, Brinson Partners; D-10370, Putnam Advisory 
Company, Inc.; and D-10507, ANB Investment Management and Trust 
Company.
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    In the exemption applications, the applicants have represented to 
the Department that cross-trading provides certain benefits to employee 
benefit plans. For example, if a plan needs to sell certain securities, 
the potential negative impact that such transaction may have on the 
price of the security if the transaction had been executed in the open 
market may be avoided through the use of a cross-trade. In addition, 
both the buyer and seller save the transaction costs (e.g., brokerage 
commissions or the bid-offer spread) that would otherwise have been 
paid to a broker-dealer for executing the transaction as an agent. 
Finally, both parties to the cross-trade benefit by avoiding the 
uncertainty of whether they will be able to find a counter-party for a 
proposed trade.
    Applicants have also represented to the Department that cross-trade 
opportunities may be triggered by a number of events. For example, the 
investment guidelines or objectives for one account may dictate that 
certain securities should be sold, but those same securities may be on 
the investment manager's ``buy list'' for other accounts. Thus, one 
account or fund may be selling a particular security at the same time 
that another account or fund may need to buy that security. For 
instance, one account may need additional liquidity while another 
account has excess cash that needs to be invested. Similarly, one 
account may be too heavily invested in a particular security while 
another account may have a need for that security.
    While recognizing the advantages of cross-trading to plans, the 
Department has particular concerns where managers have investment 
discretion over both sides of a cross-trade transaction. The conditions 
contained in the Department's prior individual exemptions were intended 
to address these concerns and to safeguard plans against the inherent 
conflict of interest which exists when there is a common investment 
manager for both sides of a transaction. In this regard, the conditions 
incorporated into these exemptions were designed to protect plans 
against the potential that an investment manager may exercise 
discretion to favor one account over another; e.g., in the pricing of a 
particular cross-trade, in the decision to either buy and/or sell 
particular securities for an ERISA account, or to allocate securities 
among accounts including ERISA accounts.
    Specifically, the Department's concerns are illustrated by, among 
other things, the potential for an investment manager to:
    (i) Place relatively illiquid securities into ERISA accounts in 
order to, among other reasons, shift anticipated losses away from, or 
provide artificial liquidity and price stability for, favored accounts;
    (ii) Use ERISA accounts as buyers or sellers of securities at 
particular times in order to promote the interests of more favored 
client accounts;
    (iii) Allocate favorable cross-trade opportunities, and the 
transaction cost savings associated with such trades, to favored client 
accounts, such as those that have a performance-based fee arrangement 
with the manager in order to either increase the manager's fees or 
demonstrate superior investment performance;
    (iv) Allow cross-trade opportunities to affect the underlying 
investment management decision as to which securities to buy or sell 
for particular ERISA accounts; and
    (v) Use cross-trades to avoid the potential market impact of large 
trades on certain accounts where such trades may not be in the best 
interests of all accounts involved or may not result in the best 
execution for the acquisition or sale of such securities.

Types of Individual Exemptions Granted by the Department

    The individual exemptions that the Department has granted in the 
past for cross-trading fall into two categories: (1) Those for Index 
and Model-Driven Funds; and (2) those for actively-managed or 
discretionary asset management arrangements.
    In the Index Fund programs, trading decisions are ``passive'' or 
``process-driven'' because the investment manager has been hired to 
invest money in a formulaic way that, for example, tracks the rate of 
return of an independently maintained index by either replicating the 
entire portfolio of the index or by investing in a representative 
sample of such portfolio. Model-Driven funds are based upon formulas by 
which an ``optimal'' portfolio is created to implement some specific 
investment strategy (e.g., hedge funds). While these ``process-driven'' 
programs ostensibly may be implemented only by investment in an index 
replicating portfolio (in the case of index funds) or some set 
``optimum'' portfolio (in the case of model-driven funds), as noted 
below, selection of individual securities for such ``process-driven'' 
strategies may involve a more subtle exercise of discretion by an 
investment manager than the Department previously believed.
    In actively-managed programs, trading decisions are made by 
individuals that have been hired to select particular securities as 
professional investment managers for ``actively-managed'' accounts.
    The conditions for both types of exemptions are summarized below.
Index and Model-Driven Funds
    1. The index used by the funds or accounts is established and 
maintained by an independent organization which is in the business of 
providing financial information to institutional clients.

[[Page 13698]]

    2. Discretion of the manager is limited because only certain 
``triggering events'' effecting the composition or weighting of 
securities included in the index or model will give rise to a cross-
trade opportunity.
    3. The triggering events are generally outside the control of the 
manager and will ``automatically'' cause the buy or sell decision to 
occur.
    4. Specific triggering events in the Index and Model-Driven Fund 
exemptions include:
    (a) Changes in the composition or weighting of the index or model 
underlying the Fund by the third party who maintains the index;
    (b) Changes in the composition or weighting of a portfolio used for 
a Model-Driven Fund resulting from an independent fiduciary's decision 
to exclude certain stocks from the Fund;
    (c) Changes in the overall investment in a Fund due to investments 
and withdrawals; and
    (d) Accumulations of cash in a Fund.
    5. Cross-trades must take place within three (3) days of a 
triggering event.
    6. Only large plans (i.e., over $50 million in assets) may cross-
trade with an Index or Model-Driven Fund in connection with specific 
portfolio restructuring programs conducted by the manager which have 
been authorized in advance by an independent plan fiduciary.
    7. The price of equity securities involved in a cross-trade must be 
the closing price of the security on the date of the trade.
Actively-Managed Funds
    1. An independent plan fiduciary must specifically authorize in 
advance a plan's participation in the cross-trade program.
    2. Cross-trade opportunities arise at the discretion of the 
investment manager but must be disclosed to, and authorized in advance 
by, an independent plan fiduciary prior to the execution of the 
proposed cross-trade. The authorization is effective for three (3) 
business days.
    3. Written confirmation of the terms and price of the cross-trade 
must be provided within 10 days of the trade.
    4. Equity securities are priced at the closing price as of the date 
of the cross-trade. As a further limitation, the cross-trade must take 
place at a price which is within 10 percent of the closing price for 
the security on the day before the manager receives authorization to 
engage in a cross-trade.
    5. Unless the condition is specifically waived by the independent 
fiduciary, the cross-trade must involve less than 5 percent of the 
aggregate average daily trading volume for the security for the week 
immediately preceding the authorization of the transaction.
    Other pertinent conditions applicable to both Index and Model-
Driven Funds as well as Actively-Managed Funds.
    1. Securities involved in a cross-trade must be securities for 
which there is a generally recognized market.
    2. The investment manager must not charge or receive any 
commissions or other fees in connection with the cross-trade.
    3. The price for any debt security involved in a cross-trade must 
be determined in accordance with objective and reputable market sources 
which are independent of the investment manager (e.g., the methodology 
described under rules promulgated by the Securities and Exchange 
Commission (SEC) for mutual funds, as discussed further below).
    4. A fair system for allocating cross-trade opportunities among 
managed accounts has been required, with such allocation being made on 
an objective basis (e.g., pro rata) among buying and selling client 
accounts.

Issues and Developments

    Through the development of cross-trading exemptions and enforcement 
proceedings the Department has become aware of new issues that have the 
potential to impact or change exemption policy involving cross-trading 
transactions. The Department recognizes that it is important to retain 
the flexibility to review our exemption policy in the context of 
changed circumstances or new facts that may be brought to our 
attention. Thus, one of the primary objectives of this notice is to 
request information from interested persons, e.g., plan fiduciaries, 
investment management firms, securities industry representatives and 
securities exchanges that may be affected by the Department's exemption 
policy for cross-trades of securities by employee benefit plans.
    In the ``process-driven'' context, it has been represented to the 
Department that investment managers who maintain accounts or pooled 
funds often attempt to track the rate of return of an independently 
maintained third party index (e.g., the Standard & Poors 500 Composite 
Stock Price Index a/k/a the S&P 500 Index, the Wilshire 5000 Index, the 
Russell 2000 Index). These pooled funds are often collective investment 
funds established and trusteed by large banks that manage money for 
institutional investors, including employee benefit plans. Under the 
Department's individual exemptions, such funds usually cross-trade 
pursuant to certain narrowly-defined ``triggering events'' that were 
represented to involve little, if any, discretion on the part of the 
investment manager.
    In the past, various applicants represented to the Department that 
the investment strategy of most Index Funds was to merely replicate the 
capitalization-weighted composition of a particular index. However, the 
Department now understands that the process of replication of an index 
may be more subtle since many, if not most, Index Funds do not totally 
replicate the exact portfolio of the index that is being tracked. In 
many instances, the manager maintains some discretion to select 
particular securities to track the rate of return of the overall index 
without actually holding all of the securities included in the index. 
In addition, some Index Funds are designed to exceed the rate of return 
of the index by altering the composition or weighting of the portfolio 
designated by the organization that maintains the index. These 
``enhanced'' Index Funds often have strategies that resemble actively-
managed accounts.
    Model-Driven Funds, on the other hand, are portfolios that apply 
specific investment philosophies and criteria in formulaic fashion to 
create a specialized portfolio. Model-Driven Funds come in many 
different forms (e.g., hedge, sector, contra, etc). Some Model-Driven 
Funds seek to transform the capitalization-weighted or other specified 
composition of an index in order to accomplish certain goals. Such 
goals vary from client-initiated instructions to delete certain stocks 
to mathematical formulae designed to focus on certain investment 
criteria (e.g., price-earnings ratios) at certain times to achieve a 
rate of return for the portfolio that exceeds that of the index. Thus, 
some Model-Driven Funds merely appear to be a more sophisticated type 
of ``enhanced'' Index Fund.
    There are also indications that, in many cross-trading programs for 
Index and Model-Driven Funds, the manager may retain a degree of 
discretion in selecting securities for the Funds' portfolios. Further, 
it appears that, in weighting a particular tracking factor for an index 
or model, the manager can produce desired cross-trade opportunities. 
For example, by factoring in the liquidity or the availability of a 
security within the control of the manager, the manager can produce 
more cross-trading opportunities for that particular security by the 
accounts within the control of the manager. Thus, the process of 
replicating an independently maintained index or model may not be as 
automatic as

[[Page 13699]]

previously described to the Department in the relevant exemption 
applications. At this point, the Department is uncertain as to the 
degree of discretion utilized in Index and Model-Driven Funds and 
believes it would be helpful to obtain further information on this 
matter.
    A number of interested persons have suggested to the Department 
that, in developing standards and safeguards in individual exemptions 
involving cross-trade transactions, particularly those involving 
actively-managed accounts, the Department should adopt the methodology 
approved by the SEC for cross-trades of equity or debt securities by 
mutual funds. In this regard, the SEC permits cross-trading of 
securities if the transactions are accomplished in accordance with SEC 
Rule 17a-7 (Rule 17a-7 or the Rule).9
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    \9\ 17 CFR 270.17a-7.
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    Rule 17a-7 is an exemption from the prohibited transaction 
provisions of section 17(a) of the Investment Company Act of 1940, 
which prohibit, among other things, transactions between an investment 
company and its investment adviser or affiliates of its investment 
adviser. Thus, Rule 17a-7 permits transactions between mutual funds and 
other accounts that use the same or affiliated investment advisers, 
subject to certain conditions that are designed to assure fair 
valuation of the assets involved in the transaction and fair treatment 
of both parties to the transaction.10 Even so, the 
requirements of Rule 17a-7 are only applicable to transactions and 
entities regulated under the Investment Company Act of 1940, and such 
requirements are not otherwise applicable to other entities--such as 
employee benefit plans.11
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    \10\ Among the conditions of Rule 17a-7 are the following 
requirements: (a) The transaction must be consistent with the 
investment objectives and policies of the mutual fund, as described 
in its registration statement; (b) the security that is the subject 
of the transaction must be one for which market quotations are 
readily available; (c) no brokerage commissions or other 
remuneration (other than customary transfer fees) may be paid in 
connection with the transaction; and (d) the mutual fund's board of 
directors (i.e., those directors who are independent of the fund's 
investment adviser) must adopt procedures to ensure that the 
requirements of Rule 17a-7 are followed, and determine no less 
frequently than quarterly that the transactions during the preceding 
quarter were in compliance with such procedures.
    \11\ 17 CFR 270.17a-7.
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    An essential requirement of Rule 17a-7 is that the transaction be 
effected at the independent current market price for the security 
involved. In this regard, the ``current market price'' for specific 
types of securities is determined as follows:
    (1) If the security is a ``reported security'' as that term is 
defined in Rule 11Aa3-1 under the Securities Exchange Act of 1934 (17 
CFR 240.11Aa3-1), the last sale price with respect to such security 
reported in the consolidated transaction reporting system 
(``consolidated system'') or the average of the highest current 
independent bid and lowest current independent offer for such security 
(reported pursuant to Rule 11Ac1-1 under the Securities and Exchange 
Act of 1934 (17 CFR 240.11Ac1-1)) if there are no reported transactions 
in the consolidated system that day; or
    (2) If the security is not a reported security, and the principal 
market for such security is an exchange, then the last sale on such 
exchange or 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; or
    (3) If the security is not a reported security and is quoted in the 
NASDAQ system, then the average of the highest current independent bid 
and lowest current independent offer reported on Level 1 of NASDAQ; or
    (4) For all other securities, the average of the highest current 
independent bid and lowest current independent offer determined on the 
basis of reasonable inquiry.12
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    \12\ 17 CFR 270.17a-7(b)(1)-(4).
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    It is our understanding that proponents advocating the adoption of 
a similar exemptive standard for cross-trading by plans argue that, by 
pricing a cross-trade pursuant to the procedures described in Rule 17a-
7, employee benefit plans will be protected from the concerns embodied 
in ERISA because one plan cannot be favored over another by the common 
fiduciary determining the appropriate value of the cross-traded 
security. This argument assumes that if both sides of a cross-trade 
transaction receive a fair and objectively determined price for a 
security, there should not be any concern about potential fiduciary 
abuses under ERISA in connection with the transaction.
    The Department believes that this assumption may reflect a 
misunderstanding of the purposes underlying ERISA. ERISA's fiduciary 
responsibility and prohibited transaction provisions are designed to 
help assure that the fiduciary's decisions are made in the best 
interest of the plan and not colored by self-interest. These provisions 
require that a plan fiduciary act with an ``eye single'' to the 
interests of the plan involved in the transaction.13 
Therefore, the Department is not convinced that reliance upon an 
objective fair price alone will ameliorate the conflicts described 
above, such as the potential for ``cherry picking'' or ``dumping'' of 
securities or allocating investment opportunities among client accounts 
in a manner designed to favor one account over the other.
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    \13\ See ``Donovan v. Bierwirth'', 680 F.2d 263, 271 (2d. Cir.), 
cert. denied 104 S.Ct. 488 (1982).
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    Further, the Department notes that, even where cross-trades take 
place at an appropriate market price or, when no market price is 
available, at a price set through use of the methodology described in 
Rule 17a-7, a per se violation of section 406(b)(2) of ERISA may occur 
even if the result is favorable to the plans involved.14 
Moreover, the mechanism employed under Rule 17a-7 to set the price of a 
security for a cross-trade may not take into account the transacting 
plan's specific interest in using its position to affect the 
transaction price in its favor on the open market. Setting a 
transaction price pursuant to this rule appears to presume that the 
trade itself cannot impact the market price and, therefore, that 
neither party has an interest in performing the trade on (or off) the 
market. More likely, however, a potential purchaser of securities would 
find lower prices in the marketplace if there were more sellers than 
purchasers in the marketplace at the time of the cross-trade. 
Similarly, a seller would find higher prices in a marketplace populated 
by more purchasers at the time of the cross-trade. When an investment 
manager decides to engage in an off-market transaction, particularly 
with thinly-traded securities, the result is that the effect of the 
transaction itself on the marketplace may be removed.
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    \14\ See, Cutaiar, supra.
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    The Department notes further that Rule 17a-7 allows certain 
securities to be priced based on the last sale price for such 
securities on the exchange.15 If a manager anticipates a 
drop in stock prices, such manager could decide to favor a buying 
client by waiting during the day for the stock price to drop before 
engaging in a cross-trade where the seller could be an ERISA account. 
The ability of the Department to address these issues would be lacking 
under any approach which focuses primarily upon ensuring that there is 
a fair and objective price for a cross-traded security under the 
requirements of Rule 17a-7.
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    \15\ 17 CFR 270.17a-7(b)(1) and (2).
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    Therefore, the Department has thus far been unable to conclude that

[[Page 13700]]

reliance solely on Rule 17a-7 would adequately protect employee benefit 
plans in situations where an investment manager exercises discretion 
for both sides of a cross-trade.16 However, in recognition 
of the interest in the approach under Rule 17a-7, the Department 
specifically invites responses from interested persons on the 
protections afforded to plans by this Rule.
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    \16\ See also PTE 86-128, 51 FR 41686, 41692 (Nov. 18, 1986).
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B. Issues Under Consideration

    The Department is issuing this notice to provide interested persons 
with an opportunity to submit information and responses which will be 
considered by the Department in developing exemptions for transactions 
involving cross-trades of securities by investment managers.
    In order to assist interested parties in responding, this notice 
contains a list of specific questions designed to elicit information 
that the Department believes would be especially helpful in developing 
additional exemptions. The following questions may not address all 
issues relevant to the development of standards and safeguards for 
cross-trades. Therefore, the Department further invites interested 
persons to submit responses on other issues that they believe are 
pertinent to the Department's consideration of this matter.

Specific Questions

    1. Would the development of a class exemption which covers all 
types, or any type, of cross-trading programs be in the interests and 
protective of employee benefit plan investors?
    2. Should the Department develop separate class exemptions for 
cross-trades of securities by (i) actively-managed accounts, and (ii) 
``process-driven'' accounts?
    3. Should the Department develop consistent conditions in 
individual exemptions which would then facilitate the use of PTE 96-62? 
17
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    \17\ PTE 96-62 (61 FR 39988, July 31, 1996) is a class exemption 
granted by the Department which permits certain authorized 
transactions between plans and parties in interest. The class 
exemption applies to prospective transactions between employee 
benefit plans and parties in interest where such transactions are 
specifically authorized by the Department as having terms, 
conditions and representations which are substantially similar to 
two or more individual exemptions previously granted by the 
Department within the 60-month period prior to the written 
submission filed in accordance with such class exemption.
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    4. What effect, if any, will each of the following have on cross-
trading programs?
    a. The move to decimalization of stock quote spreads,
    b. The emergence of electronic proprietary trading systems (e.g., 
Reuters' Instinet, London's Seaq International, Investment Technology 
Group's Posit, and AZX's Arizona Stock Exchange),
    c. The growth of block trading in the so-called ``upstairs market'' 
on the NYSE or other national securities exchanges, and
    d. Other market developments.
    5. Will the development of proprietary trading systems impact on 
the requirements for an exemption permitting cross-trading of 
securities by plans with the same investment manager?
    6. Are there real savings to plans from cross-trading when other 
market options are available?
    7. What are the ``costs'' associated with doing a transaction off-
market?
    8. Will trading by other investors on securities exchanges be 
affected by the widespread use of cross-trading programs for securities 
transactions by employee benefit plans?
    9. Are cross-trades beneficial only when the securities involved 
represent a significant percentage of the average daily trading volume 
of such securities?
    10. How does an investment manager who is a fiduciary of a plan 
with discretion in a cross-trade, who also has discretion for other 
accounts in the same cross-trade, act ``solely in the interest of'' the 
plan account?
    11. Does a cross-trade which avoids ``adverse market impact'' for 
one side of a transaction truly benefit both sides of that transaction?
    12. In order to act in an employee benefit plan's best interest, 
should an investment manager attempt to negotiate a better price for a 
security before engaging in a cross-trade?
    13. Would it ever be in an employee benefit plan's best interest to 
purchase a security through a cross-trade that the plan would not have 
otherwise purchased?
    14. Where an investment manager has performed an analysis of a 
range of securities, would it ever be in a plan's best interest to 
purchase a security through a cross-trade that was not otherwise the 
superior security as indicated by the investment manager's analytics?
    15. If an employee benefit plan purchased a security through a 
cross-trade that was not the most appropriate security for the plan at 
the time of the transaction pursuant to an investment manager's model 
or index, could such a transaction be viewed as being in the plan's 
best interests if the plan was adequately compensated for providing an 
accommodation to the selling entity? If so, how could the market value 
of such an accommodation be determined by the investment manager?
    16. Do cross-trade programs tend to benefit larger accounts over 
smaller ones?
    17. What is the best way to establish a price for cross-traded 
securities? (e.g., the ``current market price'' under SEC Rule 17a-7, 
the closing price for stocks traded on a nationally recognized 
securities exchange, the ``volume weighted average price'' for equity 
securities traded on an exchange, 18 the average between the 
current ``bid'' and ``ask'' quotations from reputable independent 
dealers and market-makers--particularly for debt securities where no 
exchange prices are available, etc.)
---------------------------------------------------------------------------

    \18\ The ``volume weighted average price'' calculates the 
average price, weighted by the volume of each trade during the 
course of the day and, according to some market analysts, provides a 
more refined view of the market behavior of a specific security, 
with time, size and exchange filters.
---------------------------------------------------------------------------

    18. Given the variety of methods for trading of equity securities 
and the fact that many trades are conducted after a particular exchange 
has closed for the day, what is the current understanding of the 
meaning of the term ``closing price,'' as utilized as a condition in 
the Department's current individual exemptions?
    19. Will volume restrictions on the number of shares of a 
particular security that can be cross-traded ameliorate the potential 
for abuse that may occur? If so:
    a. What should the volume restrictions be?
    b. If particular cross-trades would exceed these limits, should the 
manager be able to engage in the transaction if certain disclosures are 
made to an independent plan fiduciary?
    20. Are the computer models which ``drive'' portfolio selections 
made by a manager for an index or model-driven fund capable of being 
manipulated by such managers in order to produce more cross-trade 
opportunities for a particular fund?
    21. What degree of discretion is provided to investment managers of 
index or model-driven funds to affect more or less cross-trade 
opportunities? To the extent that investment managers have such 
discretion:
    a. Could the exercise of such discretion only become apparent upon 
a detailed examination of the mathematical assumptions used in each 
computer model and, if not, how else could such actions be discovered?

[[Page 13701]]

    b. Could the exercise of such discretion create ``false liquidity'' 
or ``false price stability'' for a particular security and, if so, 
would that create future problems for the portfolio when large amounts 
of such security must be sold in the open market?
    22. Could exemptions for cross-trading programs involving employee 
benefit plans provide a commercial advantage to investment managers 
with larger amounts of assets under management and, if so, to what 
extent?
    23. Could an efficient cross-trading program provide an investment 
manager with commercial advantages over competitors who do not choose 
to have, or are unable to implement, such programs and, if so, to what 
extent?
    24. Where an investment manager has discretion on both sides of a 
transaction, can cross-trading of securities be utilized to:
    a. ``Dump'' particular securities on less favored accounts to 
promote the interests of more favored accounts,
    b. ``Cherry-pick'' particular securities from less favored accounts 
to promote the interests of more favored accounts,
    c. Promote ``front-running'',
    d. Allocate favorable cross-trade opportunities to certain client 
accounts to benefit the manager's ultimate compensation, and
    e. Otherwise provide a benefit to the investment manager, another 
client of the investment manager or any other person or entity at an 
employee benefit plan's expense?
    25. What new terms or conditions could the Department impose in an 
exemption to protect any plans involved in cross-trading from potential 
abuses, such as those listed in question 24?
    All submitted responses will be made a part of the record of the 
proceeding referred to herein and will be available for public 
disclosure.

    Signed at Washington, D.C., this 16th day of March, 1998.
Alan D. Lebowitz,
Deputy Assistant Secretary of Program Operations, Pension and Welfare 
Benefits Administration, Department of Labor.
[FR Doc. 98-7271 Filed 3-19-98; 8:45 am]
BILLING CODE 7708-01-P