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November 2006
This report was produced by the Advisory Council on Employee Welfare
and Pension Benefit Plans, which was created by ERISA to provide advice to
the Secretary of Labor. The contents of this report do not necessarily
represent the position of the Department of Labor. |
The 2006 ERISA Advisory Council formed a Working Group
to study the plan asset regulation (DOL Reg. Sec. 2510.3-101), which
became effective March 13, 1987, and cross-trading.
Plan Asset Rules And Exemptions
The plan asset regulation describes circumstances in
which there is a “look through,” which, if applicable, treats not only
the interests in an investment fund owned by ERISA covered plans as “plan
assets,” but also the assets of the investment fund as “plan assets.”
If the look through applies, the ERISA fiduciary and prohibited
transaction sections apply to parties dealing with the assets of the
investment fund, such as the investment fund’s investment manager. While
it is possible that if the general partner or manager of the investment
fund meets the definition of a qualified professional asset manager (“QPAM”),
many of the possible ERISA issues would be avoided, serious concerns
remain.
The existing exemptions from “look through”
treatment are, in many cases, difficult to apply and administer. This is
particularly true for hedge funds, an increasingly large part of the
marketplace, in which the identity of potential investors and the nature
of underlying assets may make existing exemptions unavailable. The
regulation has been effective for almost twenty years, with the result
that significant economic changes have occurred and an extensive track
record has been built up regarding the application of the rules in real
situations. However, few advisory opinions have been issued in this area
and many important questions remain unresolved. Legislation, specifically
the Pension Protection Act of 2006 (“PPA”), was adopted during our
study, which revised some of the plan asset rules. The PPA also added a
prohibited transaction exemption for service providers.
But important issues remain. The desired result of this
study was a determination of whether:
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The regulation itself should be modified beyond that
required by the legislative changes.
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Additional DOL action in the form of advisory
opinions or otherwise, are appropriate to clarify the revised plan asset
regulation.
Cross-Trading
“Cross-trading” generally describes the situation
in which a third party manages two accounts, one wishing to buy a security
and the other wishing to sell the same security. In those circumstances,
the manager could “cross” the trades between the accounts rather than
involving a broker-dealer. Cross-trades save transaction costs and may
save market-impact costs. If one of the two accounts has ERISA plan
assets, the cross-trade, unless exempted, is a prohibited transaction. The
DOL has issued a limited class exemption (PTE 2002-12) for cross-trading
by index/model-driven funds. There are differences of opinion regarding
whether the economic benefits from cross-trading outweigh the potential
risks.
Numerous additional situations involving plans occur
because the current state of authority does not permit trades between
qualified funds (defined benefit or defined contribution plans) of the
same sponsor, or for that matter between plan sponsor and plan, when it is
determined that each entity would benefit by trading without going through
the exchange. These trades, while somewhat more common in the equity
markets, will also involve fixed income investments where plans make every
attempt to maximize the trade opportunities and minimize market impact.
The PPA also permits cross-trading in additional
circumstances with limitations and conditions.
The desired result of this study is a determination of
whether the DOL should issue broader exemptive relief for cross-trading.
Respectfully submitted
Advisory Council Working Group Members
-
Edward Mollahan (Working Group
Chair), JPMorgan Chase Bank
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William Scogland (Working Group Vice
Chair) Jenner & Block LLP
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Sherrie Grabot (Advisory Council
Chair) GuidedChoice, Inc.
-
James McCool (Advisory Council
Co-Chair) Charles Schwab
-
Willow Prall, DeCarlo & Connor
-
Neil Gladstein, International
Association of Machinists & Aerospace Workers
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Dennis Simmons, The Vanguard Group
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Kathryn Kennedy, The John Marshall
Law School
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Lynn Franzoi, Fox Entertainment
Group, Inc.
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Edward Schwartz, Gregory J. Schwartz
Co, Inc.
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Christopher Rouse, Windham Brannon,
PC
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Robert Archer, Meyer, Suozzi,
English & Klein, P.C.
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Charles Clark, Aon Consulting
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Timothy Knopp, Central Oregon
Builders Association
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Richard Landsberg, Nationwide
Financial Services
Questions Distributed to Potential Witnesses*
Plan Asset Rules And Exemptions
-
Should the significant benefit plan investor test (
the “SBPI Test”) be revised by raising the threshold from 25% to 50%,
as in proposed legislation, or even higher?
-
Should the SBPI Test be revised by eliminating some
or all of the non-ERISA benefit plan investors from the determination, as
is also contained in proposed legislation?
-
Should the SBPI Test be revised in other respects?
-
How should feeder funds (and similar entities) be
treated for the SBPI Test? That is, if a feeder fund itself is over
whatever the threshold ownership is for the SBPI Test, for purposes of
testing the main fund under the SBPI Test, is that feeder fund counted as
100% BPI or only the proportionate part? Recently issued DOL authority in
the insurance area may indicate the latter approach.
-
What clarifications may be needed to the definition
of “operating company?”
-
What revisions and/or clarifications are needed with
respect to the venture capital operating company (“VCOC”) definition?
-
Are particular changes needed to the “management
rights” portion of the VCOC rules? Should those rules be different for
investments in foreign companies?
-
Should the rules requiring an escrow prior to VCOC
qualification be revisited?
-
What revisions and/or clarifications are needed with
respect to the real estate operating company (“REOC”) definition?
-
Is further clarification needed of the “management
and development” rules?
-
Should DOL Reg. Sec. 2510.3-101(h)(3) be changed to
exclude plans which are not subject to ERISA?
-
What other revisions to the plan asset rules may be
appropriate?
-
In all cases, should any recommended changes be
made by revising the regulations, issuing additional advisory opinions,
both, or otherwise?
Cross-Trading
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Describe and quantify the potential savings from
permitting cross-trading by employee benefit plans.
-
What safeguards would you propose to minimize the
risks?
-
Would the safeguards focus on determining a fair
price, disclosure, other?
-
Are any ERISA safeguards required beyond those
already provided under the Investment Company Act of 1940?
-
Among the potential abuses that have been cited are
parking illiquid securities in disfavored ERISA accounts, unfair
allocation of favorable cross-trade opportunities, favoritism for some
accounts which may disadvantage other accounts in other contexts, etc.
What evidence exists regarding the prevalence and seriousness of such
practices?
* Not all questions asked were specifically responded
to or addressed in testimony.
The scope of the inquiry for the Working Group and the
attendant questions were given to all of the witnesses in advance of
testimony. The witnesses were told that the questions were merely a
starting point to generate thought and discussion of the scope of the
Working Group. The questions were not intended to limit the parameters of
testimony.
The Working Group solicited testimony of witnesses from
a broad cross-section of the qualified retirement plan industry. The
witnesses and the dates of the testimony were as follows:
Roster Of Speakers
August 11, 2006
Ivan Strasfeld and Fred Wong, U.S. Department of Labor
John Gaine, Managed Funds Association
Alan Wilmit, The Goldman Sachs Group, representing the
Securities Industry Association
L. Randolph Hood, Prudential, representing the American
Benefits Council
Gary Glynn, U.S. Steel and Carnegie Pension Fund,
representing the Committee on Investment of Employee Benefit Assets
Grant Johnsey, Northern Trust Institutional Investors
September 20, 2006
Randall Dodd, Financial Policy Forum
Scott Lopez, Wellington
Henry Hopkins, T.Rowe Price
Mary McDermott-Holland, Franklin Portfolio Associates
William A. Schmidt, Kirkpatrick & Lockhart
Nicholson Graham LLP
Damon Silvers, AFL-CIO
Norman Stein, University of Alabama Law School
The American Association of Retired Persons (“AARP”)
and the North American Securities Administrators Association (“NASAA”)
made written submissions.
Messrs. Hopkins, Lopez and Schmidt and Ms.
McDermott-Holland appeared together as a panel representing the Investment
Adviser Association and the Investment Company Institute.
Some organizations that furnished witnesses also made
written submissions.
Applicable Definitions
-
DB: Defined Benefit Pension Plan.
-
DC: Defined Contribution Pension Plan.
-
PPA: Pension Protection Act
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QPAM: Qualified Professional Asset Manager as defined
in DOL Prohibited Transaction Class Exemption 84-14, as amended
-
REOC: Real Estate Operating Company
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SBPI: Significant Benefit Plan Investor
-
VCOC: Venture Capital Operating Company
Plan Asset Rules And Exemptions
In view of the passage of the PPA, this is a good
opportunity for the DOL to revisit the plan asset regulations and to
provide additional guidance to alleviate existing confusion and
uncertainty, all in the context of the PPA changes.
Recommendation 1: We recommend that the DOL bring clarity to the term “class
of equity interests.” We did not have a consensus to recommend that the
significant benefit plan investor (“SBPI”) test be applied on an
aggregate basis. It was our consensus view that the DOL should provide
meaningful and specific guidance as to the definition of “class.” That
guidance might provide an exclusive list of factors that are to be
considered in determining whether there are separate classes -- e.g.,
convertibility, voting rights, liquidity, share of earnings or loss, etc.
Recommendation 2: We recommend that, by regulation or the issuance of
prohibited transaction class exemption(s), the DOL ameliorate prohibited
transaction concerns in the investment fund context by exempting
non-abusive transactions. Recognizing that the PPA has taken a significant
step in this direction regarding service providers, we recommend that the
DOL broaden the relief with respect to investment funds.
Recommendation 3: Although no witness chose to testify on the more
technical questions we posed regarding Venture Capital Operating Company (VCOC),
Real Estate Operating Company (REOC), etc., we recommend that, in the
context of revisiting the plan asset regulations, the DOL consider those
questions in the list set forth on plan asset regulations.
We heard conflicting testimony regarding the
desirability of an increase in the SBPI test percentage from 25% to 50%.
In view of the absence of a track record regarding the application of the
SBPI test as modified by the PPA, the “plan asset” recommendations we
have made above and concerns expressed in the testimony that we received,
we do not recommend that increase at this time.
Cross-Trading
Recommendation 1: We recommend that the DOL grant a prohibited
transaction class exemption for cross trading by In-House Asset Managers.
Recommendation 2: We recommend that the DOL provide guidance under the
$100 million cross trading threshold (or such lower amount as is adopted)
established by the PPA for circumstances in which plan assets may
fluctuate over and under that amount.
Recommendation 3: We recommend that exemptive relief be extended to
pooled funds with, at least, one investor with assets of, at least, $100
million (or lower amount as is adopted).
Recommendation 4: We recommend that exemptive relief be extended to allow
cross trades between plans maintained by employers in the same Controlled
Group, provided that ERISA plans within the same Controlled Group, have,
in the aggregate, assets of, at least, $100 million (or lower amount as is
adopted).
Recommendation 5: We recommend that the DOL provide exemptive relief to
extend cross trading to those plans meeting a threshold level of $50
million.
Summary of Testimony of Ivan Strasfeld and Fred Wong,
U.S. Department of Labor, August 11, 2006
Ivan Strasfeld of the DOL generally described the
effects of the PPA on cross-trading.
Fred Wong of the DOL generally described the existing
plan asset regulations. In response to a question, he indicated that the
“class” issues were probably those about which the Department receives
the most inquiries.
Summary of Testimony of Alan Wilmit, The Goldman Sachs
Group (representing the Securities Industry Association), L. Randolf Hood,
Prudential (representing the American Benefits Council), and John Gaine,
Managed Funds Association, August 11, 2006
The testimonies of Alan Wilmit, L. Randolph Hood and
John Gaine were remarkably similar. All three stated that alternative
investments could be a valuable addition to benefit plan portfolios in
appropriate circumstances, and all advocated that, in the wake of the
recently enacted legislation, the DOL revise the plan asset regulations
to:
Wilmit and Gaine advocated revising the “disregard”
rule so that it relates only to proprietary holdings of the manager and
its affiliates. Gaine further commented that the definition of “affiliate”
requires further clarification.
Gaine went on to advocate a revision to the rules under
which the “look through” rule would be applied at the time of
investment -- i.e., that it not be a moving target.
Summary of Testimony of L. Randolph Hood, Senior
Investment Manager, Prudential Financial, August 11, 2006
L. Randolph Hood is employed as a Senior Investment
Manager responsible for Prudential Financial’s $16 billion Domestic
Employee Benefit Plan. Prior to that time, Mr. Hood was responsible for
the company’s asset/liability matching in his capacity as a Senior
Investment Manager for its financial services business. Mr. Hood has had
extensive experience in equity investments and tactical asset allocation,
and has advised financial institutions for about 28 years.
Mr. Hood was present as a representative of the
American Benefits Council, a public policy organization representing
primarily Fortune 500 companies and other organizations that assist
employers of all sizes in providing benefits to employees.
Mr. Hood focused his comments on the “significant
participation” test under the Department’s plan assets regulation. Mr.
Hood stated that notwithstanding recently passed legislation, “there
still are important issues that the Department of Labor may address
through regulations.” Mr. Hood believes that the threshold for “significant
participation” should be increased from 25% to 50%. According to Mr.
Hood, this change would allow plans additional access to invest in certain
alternative asset investments - including private equity, real estate and
hedge funds - which play an important role in diversifying investment
portfolios, reducing portfolio risks and potentially enhancing investment
returns. In his view, “as a general matter, managers of alternative
asset funds will avoid becoming subject to ERISA, for good, rather than
bad reasons.”
Mr. Hood noted that ERISA’s prohibited transaction
restrictions can add additional cost, making it more difficult to execute
some strategies profitably, particularly certain hedge fund strategies.
In the course of his remarks, Mr. Hood defined “alternative
investments” as investments other than traditional stocks and bonds,
which might include private equity funds, hedge funds, and real estate
funds. Mr. Hood noted that a “fund of funds” approach has become an
often preferred approach to alternative investments. In recent years,
institutional investors - including foundations, endowments and state and
local governmental pension funds, and corporate funds - have increased
their investment portfolios in alternative investments. Mr. Hood noted
that alternative assets, especially hedge funds, may be able to support
particular plan investment objectives more effectively than traditional
investments, particularly in the area of matching plan investments to plan
liabilities. Mr. Hood cautioned that, while alternative investments can be
very helpful in the management of pension plan assets, the utilization
requires diligence in the selection and monitoring process.
In concluding, Mr. Hood believes that the 25% threshold
will continue to impose unintended and arbitrary restrictions on plan
investment opportunities, and that retirement plans with the largest
portfolios are most affected by this problem. Mr. Hood would encourage the
Working Group to recommend to the Department to take an additional step by
increasing the threshold to 50%.
Summary of Testimony of Gary Glynn, U.S. Steel and
Carnegie Pension Fund (representing the Committee on Investment of
Employee Benefit Assets), August 11, 2006
Gary Glynn’s testimony essentially advocated that the
DOL grant a long standing prohibited transaction class exemption requested
by the Committee on Investment of Employee Benefit Assets, which would
permit cross-trading by In-House Asset Managers.
Summary of Testimony of Grant Johnsey, Senior
Strategist, Northern Trust Global Investments, August 11, 2006
Mr. Johnsey’s testimony was limited to the topic of
cross-trades. The key driving forces behind the strong support for
cross-trades was the high cost of trading and the subsequent impact upon
performance. Over the past 20 years, trading costs have fallen and direct
electronic trading access has become widespread in all major markets. The
trading costs consist of three components: the commission, the spread
between the best bid and best offer prices, and the impact of changing the
balance of supply and demand in the market. A cross-trade does not help
reduce opportunity costs, which represents the missed chance to buy or
sell at a better price while waiting for the execution.
Despite the relative decline of trading costs,
cross-trading is as popular as ever; however, cross-trading has evolved
significantly. A number of investment solution providers offer a range of
services with some variation of cross-trading as a liquidity source. The
aim of such services is to reduce trading costs through cross-trades, with
little mention of or protection from the potential opportunity costs
risks.
Due to the benefits of a cross-trade, there has been
extraordinary demand from plans to cross-trade. This has led to more
services selling some variation of crossing, usually outside of the
Department of Labor’s (DOL) current cross-trade exemption. However,
cross-trade does not reduce costs in all situations and that opportunity
costs must be managed as well. It is critical for plans to distinguish
between exemption direct cross-trades and brokered cross-trades, which are
inherently more risky and potentially expensive. As a result, the
prevailing current market view on crossing has become unbalanced. It is
recommended that the DOL continue to differentiate between direct
cross-trades under the current exemption and brokered cross-trades.
Under the current 2002 class cross-trade class
exemption, relief is not provided for restructured large accounts except
in conjunction with a triggering event by a fund. Plans face a
disproportionate level of costs when undergoing a restructuring and a
widening of the class exemption to include such activity would help reduce
theses costs. Thus, two changes to the existing exemption would be
helpful: (1) the addition of a portfolio restructure as a triggering
event, and (2) the allowance of two large accounts to directly cross-trade
with one another as part of independent restructuring programs.
It is recommended that the DOL revisit the $50 million
size qualification under the definition of a large account.
Under the current class exemption, it is suggested that
other pricing options such as Volume Weighted Average Price (VWAP) or Open
price be included. Northern sees with cross-trade synergies that funds do
not necessarily fall under the model-driven fund or index fund
definitions. Thus, it is suggested that the DOL look at the trades by
types rather than by the source. A block trade, which consists of a rather
large position in a single position, could result in the potential for
abuse. In contrast, a program trade or basket of multiple equities is much
harder to manipulate. Thus, if the existing class exemption is altered,
the distinction between block and program trades should be maintained.
Cross-trading of fixed income securities offers unique
challenges in contrast with cross-trading of equities. Fixed income
trading is conducted in an over-the-counter market. Ultimately the bond’s
exact price will be determined by the market, but realized prices can vary
significantly from vended prices. In addition, these pricing systems
usually use the bid as the price without any reference to the offer price.
When establishing a price for cross-trades, two problems are encountered:
(1) the closing price for many bonds can only be estimated; thus two
pricing services could disagree on the estimated price of any given bond,
and (2) pricing services typically only deliver bid side pricing which
favors the buying account over the seller. Thus, it is difficult to ensure
that a cross-trade equally benefits both sides.
Any changes to the current class exemption should
consider additional language to include some validation of the source used
to establish the price and fairness of this price as it relates to bonds.
Summary of Testimony of Randall Dodd, Director of
Financial Policy Forum, September 20, 2006
Dr. Dodd is the Director of the Financial Policy Forum
in Washington, D. C. He has a Ph.D. in Economics from Columbia University,
and he has worked for the Joint Economic Committee of the U.S. Congress
and the Commodities Futures Trading Commission. Dr. Dodd also teaches in
the Department of Finance at John Hopkins University.
Dr. Dodd stated that in this present financial market,
many plans seek to capture higher rates of return by taking on greater
amounts of market risk. His view is that so long as the rates of return
are sufficient to justify the greater risk, this would be efficient
investment activity. Dr. Dodd provided insight about a prudent pension
fund approach in areas such as hedge fund investments.
Dr. Dodd identified three potential issues with “so-called”
hedge funds. Those are (1) fraud, where many hedge funds are under
investigation, in court or have settled charges financially; (2)
liability, where hedge funds have engaged in illegal trading activities,
and those activities expose investors not only to criminal liability, but
to substantial losses to the Fund by way of fines, penalties, legal fees,
and restitution, as well as reputational loss to the investor; and (3)
market risk.
Further elaborating on the issue of market risk, hedge
funds are not like traditional asset classes. Dr. Dodd believes that the
best hedge funds are closed to new investments or new investors. According
to Dr. Dodd, hedge funds should be brought into more of a regulatory
framework. He also expressed concerns that the investment strategy of
hedge funds was lacking in transparency even to their investors and that
hedge funds charge high fees and sometimes incur a large transactional
costs.
According to Dr. Dodd, “this investment class [hedge
funds] is fraught with a different set of investment challenges, if not
dangers, than conventional or traditional investment vehicles.” Dr. Dodd
believes, in any case, that the regulatory approach needs to be different
for hedge funds. Dr. Dodd further suggested that another course might be
to limit the extent of such investments - a policy that has also been
recommended by the Financial Economists Roundtable.
Summary of Testimony of Panel for the Investment
Adviser Association and the Investment Company Institute, September 20,
2006
The following individuals appeared on the panel for the
Investment Adviser Association and the Investment Company Institute: Henry
H. Hopkins, Chief Counsel and Vice President,
T. Rowe Price Group, Inc.; Scott M. Lopez, Director of
Global Equity Trading, Wellington Management Company, LLP.; Mary
McDermott-Holland, Senior Vice President, Franklin Portfolio Associates,
LLC; and William A. Schmidt, Attorney, Kirkpatrick & Lockhart
Nicholson Graham LLP.
The Investment Advisor Association (“IAA”) is a
not-for-profit organization that represents federally registered
investment advisory firms. The Investment Company Institute (“ICI”) is
a national association of the American investment company industry.
Scott Lopez - Scott Lopez testified that when thinking about the
benefits and risks of cross trading, it is critical to understand that the
investment decision and trading decision are two separate and distinct
functions within asset management. He indicated that some asset management
firms separate the two functions so that they are conducted by separate
groups of professionals and that other firms are organized so that
portfolio managers are responsible for executing their own investment
decisions. Regardless of the model, the investment decision is independent
from the choice of trading venue.
He noted that skeptics of cross trading question why or
how an asset management firm can have one account that wants to buy while
another account that wants to sell the security at the same time. He
indicated that there are several legitimate reasons for this. One reason
that he cited was that asset management firms often manage client assets
in a variety of different styles and while the stock may no longer be
appropriate for a small cap portfolio because its market value has grown
too large, that same security could be attractive to a mid cap portfolio.
Mr. Lopez indicated that asset management firms, as
fiduciaries to benefit plan clients, have the obligation to seek the most
favorable execution (“best execution”) for all orders placed by their
portfolio managers on behalf of client accounts. He defined “best
execution” as the process of executing portfolio transactions at prices,
and, if applicable, commissions that provide the most favorable total cost
or proceeds reasonably obtainable under the circumstances.
To illustrate the magnitude of impact cost that can be
saved through cross trading, Mr. Lopez indicated that a $10 million
investment in Hewlett Packard Company can be expected to have an average
impact cost over time of approximately 14 basis points or $14,000. He
further stated that a $10 million investment in a smaller cap stock such
as Dominos pizza is expected to have over 150 basis points of impact or
over $150,000. He stated that the potential to save these costs by cross
trading is meaningful.
In his testimony, he also indicated that opponents of
cross trading have pointed to the risk of abuse, especially portfolio
dumping where less favored clients act as a dumping ground for undesirable
positions held by more favored clients. He noted that the implicit
argument is that smaller plans are not sophisticated and therefore would
not be able to detect whether this type of abuse was happening to them.
He identified two problems with this line of reasoning.
First, he indicated that the correlation between plan size and its
sophistication is tenuous at best. Second, he indicated that while the
potential for abuse may be real, those abuses relate to the investment
decision and not the choice of trading venue. According to Mr. Lopez,
restricting cross trading will not prevent improper portfolio management
decisions and only serves to deprive ERISA plans of an important and
highly beneficial trading venue.
He also commented on testimony presented to the
Advisory Council on August 11, 2006 by Grant Johnsey regarding the
opportunity costs of cross trading. He noted that Mr. Johnsey argued in
his testimony that a cross trade does not help reduce opportunity costs
and actually tends to increase them. He indicated that he agrees with Mr.
Johnsey that using a closing price for an order placed earlier in the day
has an opportunity cost. However, he stated that the Pension Protection
Act of 2006 does not require that the closing price be used for cross
trades. Rather, the Act follows the requirement for registered mutual
funds that cross trades must be executed at the independent current market
price of the security. Mr. Lopez indicated that the ability to execute a
cross trade at the time of the investment decision eliminates the
opportunity cost of waiting for the closing price. He therefore believes
that Mr. Johnsey’s opportunity cost argument does not apply to orders
that are crossed pursuant to the Act.
Finally, Mr. Lopez expressed dissatisfaction with the
$100 million minimum asset test. He contended that the $100 million
minimum test actually works to the disadvantage of smaller plans by
eliminating an important cost effective trading venue. He testified that
the unintended consequence of the limit is that larger ERISA plans and
virtually all other investors will be able to avoid commissions and market
impact costs on certain trades, while smaller plans will have no choice
but to trade in the open market at a much greater cost. Mr. Lopez
expressed the view that all plans should be able to benefit from cross
trading opportunities when that option is available.
Henry Hopkins - Henry Hopkins indicated that the IAA and ICI membership
and T.Rowe Price have been actively involved for more than 30 years in
encouraging the adoption of an exemption from the prohibited transaction
rules to permit cross trade transactions involving actively managed
accounts subject to ERISA. He testified that these organizations have a
strong interest in expanding exemptive relief for these transactions
because their clients look to them to maximize the net returns on their
invested capital.
According to Mr. Hopkins, the potential for cost
savings is obvious. He advised that 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, and the commission cost associated with a
transaction involving 1,000 shares of stock can range from $60 to $120.
Over the course of a year, Mr. Hopkins indicated that these accumulated
commissions can represent a significant cost to a retirement plan. He
cited a report issued by Thomas McInish in July of 2002 that concluded
that the benefits of cross trading are clear and substantial. He also
indicated that several institutions have previously advised the Department
of cost savings in the range of $300 million a year through their cross
trading programs.
Mr. Hopkins then discussed the cross trading exemption
that was included the recently enacted Pension Protection Act (“Act”).
He noted that the exemption applies only to actively managed retirement
plans that affirmatively agree through their independent fiduciaries to
participate in cross trading activities. He applauded Congress’ efforts,
and, in particular, its decision to use SEC Rule 17a-7 under the
Investment Company Act as the framework for enacting workable exemptive
relief for cross-trade transactions. He testified that the Act’s use of
Rule 17a-7 as a framework for exemptive relief promotes regulatory
consistency and helps to provide ERISA covered investors with all the
advantages that non-ERISA investors have in ensuring that their security
trades are made at the lowest incremental cost.
He also discussed the requirement under the Act that
covered transactions be effected at the “current market price” of the
security determined in accordance with Rule 17a-7. According to Mr.
Hopkins, this has three principal advantages: 1) The method for
determining current market price under Rule 17a-7 is intended to be
completely beyond the control of the portfolio manager, 2) Rule 17a-7
provides a pricing structure that is more reflective of the most recent
market activity with respect to the security, 3) 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.
He also discussed the Act’s requirement that
investment managers adopt and effect cross transactions in accordance with
written cross trading policies and procedures that are fair and equitable
to all accounts participating in the cross trading program. He testified
that 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 Rule 17a-7. He urged 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 afforded the same opportunities for reducing
transaction costs through cross trades that are available to non-ERISA
investors.
During his testimony, he discussed other aspects of the
Act, including the client approval and reporting and record keeping
requirements. He then focused his attention on the provision of the cross
trading exemption in the Act that limits participation to those with at
least $100 million in assets.
According to Mr. Hopkins, the $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. He indicated that his
organization believes that the $100 million threshold for participating in
cross trading opportunities is unnecessary. However, if the Council is of
the position that some “sophistication” standard is essential, he
recommends that additional sophistication tests be developed that would
allow a greater percentage of plans to benefit from cross-trade
opportunities, while ensuring that the interests of such plans are
protected.
One potential way of extending the benefits of the
exemption to a broader range of plans that Mr. Hopkins discussed was to
provide exemptive relief to pooled funds, such as common trust funds,
whose assets are considered to be covered by the requirements of ERISA.
For such pooled funds, he suggested that 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
assets.
Another approach that he discussed was the use of
sophisticated consultants. He noted that in 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. Mr. Hopkins expressed the view that if a plan’s
participation in a cross trading program is reviewed by a party who is
unrelated to investment manager engaging in the cross trade, and who has
the necessary sophistication to properly evaluate the plan’s
participation in the cross trade program, the plan should not be precluded
from participation in a cross trading program that otherwise meets the
requirement of the Act.
Mary McDermott-Holland - Mary McDermott-Holland testified that controlling
transactions costs is a key to providing good investment performance
because the explicit and implicit transaction costs incurred in trading
detract from the investment return obtained by the portfolio managers.
She indicated that the Pension Protection Act gives
flexibility to execute cross trades among actively managed accounts.
However, because of the $100 million threshold requirement, they have
determined that several of their ERISA accounts could not take advantage
of this new exemption. She stated that they believe that there is a
significant benefit, as well as a fairness issue, to all clients having
the ability to participate in the cross trading opportunities.
She indicated that there would be substantial savings
for both the buyer and the seller by permitting cross trades among various
clients. However, she indicated that estimating the total actual savings
may be difficult. In particular, she advised that while it is not a far
stretch to figure the savings of the explicit costs, the implicit costs
can be more difficult to project.
She testified that a ITG Solutions Network study found
that the average transaction cost per fund across all assets classes was
19 cents a share. This consisted of about 15.5 cents a share in implicit
costs and 3.5 cents a share in explicit costs or commissions. These
figures came from their peer group database from September of ‘05
through August of ‘06 and represent approximately 100 investors totaling
$2.1 trillion.
According to Ms. McDermott-Holland, transaction costs
can accumulate quickly and over the long term can have a real impact on
the return of client portfolios. She indicated that the ability to cross
trade is a valuable tool for the trader in satisfying the best execution
obligations of two clients on separate sides of the same stock. Today, she
advised that almost all of the Mellon subsidiaries participate in
commercially available crossing networks.
She indicated that there are several mechanisms that
can prevent abuses in cross trading. First, she advised that there are
legal obligations with which investment managers must comply, such as
examination by their regulators, the SEC, the DOL, banking authorities or
state insurance commissions. Second, she indicated that policies and
procedures will need to be adopted, client consent sought and obtained,
periodic reports provided to clients and a person designated by the
investment manager will have to certify annually the firm’s compliance
with the policies and procedures. The third mechanism that she discussed
was the market. According to Ms. McDermott-Holland, the investment
management market is highly competitive and an investment manager that is
not trustworthy or does not provide good investment performance or client
service will lose business.
She testified that it becomes easier to focus on
seeking best execution when there is uniformity in the rules. She
indicated that the $100 million threshold will be an unnecessary
distraction from that focus. She advised that it is unnecessary because
any ERISA plan can invest in a mutual fund and that mutual fund can engage
in cross trading. She indicated that it will be a distraction because
traders will need to be confident that the plan meets the $100 million
threshold.
She indicated that she hopes that the Department will
propose an exemption for plans below the $100 million statutory threshold.
According to Ms. McDermott-Holland, small plans should not be penalized
based on their size and need cost savings just as much, if not more, than
large plans.
William Schmidt - William Schmidt, who indicated that he was testifying
from his own perspective and not representing any particular organization,
began his testimony by focusing on what the ERISA problem is with cross
trading. He indicated that the Labor Department’s position has been that
a cross trade - at least on a discretionary basis - involves a per se
violation of the Section 406(b)(2) prohibition on a fiduciary acting in a
transaction involving a plan on behalf of a person whose interests are
adverse to the plan. He advised that it is his understanding that the
government’s position has been that a buyer and seller of securities,
even highly liquid securities, are in positions that are inherently
adverse.
He explained that the Department addressed the issue in
the context of several individual exemptions in a process that culminated
in the issuance of a class prohibited transaction exemption in 2002 (PTE
2002-12). He indicated that the 2002 exemption has resulted in some real
savings, but that the number of plans and institutions that can take
advantage of the index and model-driven exemption is limited.
He testified that the exemption in the Pension
Protection Act is potentially a much broader exemption that has much more
utility in the cross trade world. He also noted that the exemption is
subject to a number of important conditions, including: a pricing regime
that has been developed for mutual funds and has worked well under Rule
17a-7 of the Investment Company Act; independent fiduciary approval after
full and complete disclosure; a provision requiring a quarterly report
detailing the investment manager’s cross trading activity; a provision
requiring the investment manager to develop written policies and
procedures for effecting cross trades in an equitable way; a provision
requiring the investment manager to identify a person who is responsible
for reviewing compliance and requiring that person to issue an annual
report on the manager’s cross trade activities.
He also discussed $100 million threshold in the
exemption. It is Mr. Schmidt’s position that the Department should
examine whether the $100 million threshold is necessary. He noted that the
Department is authorized to grant exemptions on an individual or class
basis if it determines that its exemptions are administratively feasible,
in the interests of plans and their participants, and protective.
He identified several things for the Department to
think about in deciding whether and to what extent to use that authority.
First, the savings are there. According to Mr. Schmidt, there have been a
number of studies relating to cross trades both in the ERISA context and
otherwise and the consensus has been that the savings are there and they
are real. Second, the beneficiary of these cost savings are the plans. He
explained that the beneficiaries are not the investment managers, and, in
fact, investment managers cannot receive any kind of additional
compensation in connection with cross trades. Third, the Pension
Protection Act establishes a very workable structure which does a lot to
assure that cross trading will occur in a way that is protective of the
plans and their participants. He emphasized the requirement to have
written policies and procedures and that an identified individual has to
review those policies and procedures and on an annual basis provide its
conclusions to authorizing fiduciaries.
He also indicated that it is important to keep in mind
that everyone involved in the cross trading process - the manager and
authorizing fiduciary - is acting as a fiduciary for ERISA purposes. Two
consequences of ERISA fiduciary status that he indicated were important
are: 1) that there is no way that the manager or authorizing fiduciary can
run away from that responsibility 2) ERISA establishes a fairly
comprehensive system of remedies that can be invoked on behalf of a plan
by fiduciaries, the Labor Department and by individual plan participants
and beneficiaries.
According to Mr. Schmidt, monitoring cross trading is
not different in kind or maybe even in degree from the types of
responsibilities any plan sponsor has. He indicated that he thinks the key
has been establishing a way of making cross trading comprehensible to plan
fiduciaries.
Mr. Schmidt indicated that uncertainty might exist with
a plan hovering around $100 million. He presented the scenario where cross
trades are being performed and all of the sudden it is discovered that the
assets of the plan dropped below $100 million. He indicated that some
certainty is needed in the rule as to how you determine for a period of a
year whether a plan qualifies or not.
When asked about the use of independent consultants,
Mr. Schmidt indicated that in many cases consultants are needed - not only
for cross trades but for a variety of issues that plans encounter. On the
other hand, Mr. Schmidt indicated that there are some multi-employer plans
that have pretty substantial staffs of their own and that they may be in a
position to handle it themselves. He also indicated that in the single
employer area and in the defined benefit area, there are going to be some
pretty sophisticated people on staff even in a relatively small employer.
Mr. Schmidt also testified that he thinks that
evaluating a cross program is really no different in kind than any other
decision that a plan sponsor has to make about its investment activities.
According to Mr. Schmidt, the difference is that the Pension Protection
Act effectively takes some of the compliance burden away from the plan and
puts it on the investment manager.
Summary of Testimony of Damon Silvers, Associate
General Counsel, AFL-CIO, September 20, 2006
Mr. Damon Silvers is Associate General Counsel of the
AFL-CIO, where his responsibilities include corporate, government, pension
and general business law issues. Mr. Silvers serves on a number of
oversight boards and advisory councils.
Mr. Silvers stated that he was not opposed to investing
modest amounts of defined benefit assets in hedge funds, but, in his view,
he believed that the regulatory standards presently in effect should
remain and should not be reduced. According to Mr. Silvers, “it would be
a grave mistake for the [U.S.] Department [of Labor] to further erode
these [ERISA] protections in the belief that hedge funds are somehow
immune from conflicts of interest or the temptation to place their
interest above those of their plan clients.” Mr. Silvers is very
skeptical of any argument that favors the weakening ERISA coverage of
hedge funds (for example, by increasing the plan asset rule to a 50%
guideline).
Mr. Silvers made it clear that investments in hedge
funds should follow the “prudent expert rule,” which would assess the
value of the investment against the risks inherent to such an investment.
Mr. Silvers expressed specific concern about the Amaranth experience and
how it underscored the issues that would arise with loosening the
regulatory scheme presently in place concerning alternative investments,
as well as the prudence of hedge fund investments. Mr. Silvers also
believes that the Securities and Exchange Commission “should play a role”
with respect to regulating hedge funds.
Addressing the issue of cross-trading, Mr. Silvers
opined that there was a need to focus on what happens to the smaller fund,
which has authorized discretionary trading authority to an institution in
comparison to the other clients of that institution who are larger and
provide more business to that entity. Mr. Silvers believes that
cross-trading would primarily benefit “large funds” and he suggested a
size limitation might be appropriate under the circumstances for
cross-trading (i.e., $100 million or $500 million fund).
Summary of Testimony of Norman Stein, Professor of Law,
University of Alabama School of Law, September 20, 2006
Norman Stein is the Douglas Arant Professor of Law at
the University of Alabama School of Law. The testimony expressed his views
and he was not presenting on behalf of the University.
Mr. Stein argued that ERISA tries to prevent
fiduciaries from exploiting a conflict of interest and from doing “really
dumb stuff,” and that these two ideas need to be kept in mind when
looking at cross-trading and hedge funds. On cross-trading, Mr. Stein
feels that this should only be allowed for large plans that have the
resources and sophistication to protect their interests. Concerning the
plan asset regulations, he advocates not changing this “one iota” for
hedge funds since the Pension Protection Act has already done some
tinkering.
He described how ERISA has an underlying belief that it
is better to have rules that protect against large loss than rules that
accommodate speculative or even innovative investment strategies that
might produce above-market gains. Mr. Stein mentioned that Congress has
reinforced this attitude when it has amended ERISA and gave as an example
the new diversification provisions dealing with employee stock.
Mr. Stein stated that people forget that ERISA is
designed to cover plans of varying sizes and that have fiduciaries and
service providers with various degrees of sophistication. Rules that might
be good for a large plan using highly regarded investment professionals
may not be good with respect to a small plan utilizing less skilled
professionals, (such as the “brother-in-law of the Vice President’s
second cousin, who is rumored to have made some money in day-trading”).
Mr. Stein provided additional thoughts on
cross-trading. For example, he stated that since trading fees have come
down in recent years, there is less opportunity for cross-trading to
reduce costs. Mr. Stein also warned about three potential costs with
cross-trading:
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Favorable price to one party at the expense of another.
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Investment managers causing a plan to sell or purchase
assets in order to facilitate a trade, rather than to advance the plan’s
own investment strategies.
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Delay the consummation of buy or sell transactions and
thus lose the benefit of the market price at the time the buy/sell
decision was made by the plan fiduciary.
Although the first two potential costs are illegal
under ERISA, Mr. Stein feels that the prohibited transaction rules are a
more effective deterrent to those costs. He stated that although large
plans are equipped to protect themselves, he suspects that small plans are
not in such a position. Thus, Mr. Stein argued, any liberalization of
cross-trading should create two regulatory regimes, one for larger plans,
and one for smaller plans. He also said that professionals that facilitate
cross-trading should be required to provide plans information about
cross-trading on a regular basis to allow for appropriate monitoring.
Mr. Stein gave additional testimony on his concerns
about easing rules any further for investing in hedge funds. He argued
that given the recent easing of the investment rules and the recent
collapse of another major hedge fund, that it would be prudent to see the
what happens before extending still further the invitation for hedge funds
to pursue ERISA plan investors.
He stated that it would be more logical to reduce
investments in hedge funds since he is skeptical that hedge funds are
suitable investments, in part because of their lack of transparency. Mr.
Stein described hedge funds as a “magic box - put your money in one end,
and out the other comes dollar after dollar.” He described how some
funds have quite spectacular returns, but that other funds have lost
almost unfathomable amounts of money. He conjectured that some of the
large gains earned by some funds have come from two sources: normal rules
of chance and inflated evaluations of the illiquid property.
Mr. Stein also warned that if more plan capital can be
invested in hedge funds; then there will be more hedge funds; which will
lower the quality hedge funds. He also raised concerns that a
proliferation of hedge funds may have unpredictable effects on capital
markets as they attract more capital away from traditional investments. On
a hedge fund-of-funds, Mr. Stein stated that it is hard to see how they
could ever be a prudent investment under ERISA since it would be extremely
hard for plan fiduciaries to evaluate.
Mr. Stein also disagreed with those who argue that
hedge funds are similar to other alternative investments, such as real
estate and investor pool capital. He pointed out that unlike hedge funds,
these other alternatives are investing in real things and investors know
what they are investing in.
The Council and Mr. Stein discussed his views on
cross-trading and hedge funds in more detail. Concerning the appropriate
threshold for large plans that cross trade, Mr. Stein stated that he
thinks that $50 million is probably more appropriate than $100 million.
Summary of written submission by David Certner,
Legislative Policy Director of AARP, September 20, 2006.
AARP is a nonprofit, nonpartisan membership
organization for people 50 years old and older. It has more than 37
million members.
Mr. Certner wrote that AARP is opposed to raising the
25% asset threshold to 50% and/or looking at the percentage by total
amount of equity interest instead of determining this percentage by asset
class. He concluded: “Separately or together, these changes would
significantly reduce fiduciary protections for participants by permitting
more plan assets to be exempted from ERISA’s prohibited transaction
protections.”
The submission also discussed issued related to
pensions investing in hedge funds, including rejecting the argument that
ERISA regulation of hedge funds is unnecessary because securities, state
and common law standards may apply. Mr. Certner pointed out that the
purpose of regulation by ERISA is distinct due to the fact that pension
plans deserve more protection since they hold retirement monies and
benefit from tax exemptions. He also noted that since numerous hedge funds
are organized in offshore havens outside of U.S. regulation, they are not
subject to state law fiduciary standards.
Summary of written submission by Patricia D. Struck,
Wisconsin Securities Administrator, NASAA President, September 20, 2006
The North American Securities Administrators
Association (NASAA) is an international organization whose membership that
consists of the securities administrators in the 50 states, the District
of Columbia, the U.S. Virgin Islands, Canada, Mexico and Puerto Rico.
The submission described how the Pension Protection Act
(PPA) changed the 25% asset rules. NASAA praised Congress for not raising
the threshold to 50% as some had advocated and urged that the Department
of Labor not raise this plan asset limitation.
NASAA wrote that PPA’s removal of government and
foreign pensions from counting towards the 25% cap as potentially putting
pension plans and their participants at greater risk since more pension
assets are likely to be placed in hedge funds.
The submission discussed concerns that NASAA has about
hedge funds and how it sees hedge funds as a “poor” investment choice
for many pension plans. Issues NASAA raised included the amount hedge
funds are regulated, recent scandals involving hedge funds, and concerns
about transparency.
Summary of written submission by The Investment Adviser
Association, September 20, 2006
The Investment Adviser Association (IAA) is a national
not-for-profit organization that represents more that 450 federally
registered investment adviser firms.
Although the IAA applauded Pension Protection Act (PPA)
changes related to cross-trading, it noted that the $100 million threshold
only provides cross-trade benefits to fewer than four percent of ERISA
plans.
IAA urged the Advisory Council to recommend that the
Department of Labor take additional action to allow investment advisers to
engage in cross trading. Suggestions included allowing cross trading for
(1) all of their ERISA clients regardless of size, (2) for ERISA plans
participating in a pooled fund, and/or (3) for plans that have assets
below $100 million and retain consultants.
IAA feels that ERISA plans would be protected as long
as the class exemption includes the safeguards provided in the PPA, which
are modeled after Rule 17a-7 of the Investment Company Act of 1940.
The IAA submission also made several arguments
defending and promoting cross trading. For example, it wrote that the
decision to buy or sell a security is made separately and distinctly from
the decision to cross trade, and that it feels that the monitoring of
cross trading will be cost effective for small plans.
Summary of written submission by The Investment Company
Institute, September 20, 2006
The Investment Company Institute (ICI) with over 9,000
member companies and about 600 investment advisor members.
It praised the cross trading provisions included in the
Pension Protection Act (PPA).
ICI wrote that there are two courses of action that the
Department of Labor should take. First, the Department’s compliance
regulation should recognize what ICI views as “significant”
protections for plans and plan participants afforded by the PPA.
Second, the Department should use its exemptive
authority to allow plans with assets below $100 million to engage in cross
trades, with appropriate investor safeguards.
The submission provided greater detail in support of
the ICI’s two recommended courses of action, including a discussion of
how proper safeguards would protect plans and plan participants.
Working Group on Plan Asset Rules, Exemptions, and
Cross Trading
Meeting of August 11, 2006
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Agenda
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Official Transcript
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Statement by Gary Glynn, U.S. Steel and Carnegie
Pension Fund, representing the Committee on Investment of Employee Benefit
Assets
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Statement by Alan Wilmit, The Goldman Sachs Group,
Inc., representing the Securities Industry Association
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Statement by L. Randolph Hood, Prudential, representing
the American Benefits Council
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Statement by John Gaine, Managed Funds Association
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Statement by Grant Johnsey, Northern Trust
Institutional Investors
Meeting of September 20, 2006
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Agenda
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Official Transcript
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Statement by Randall Dodd, Financial Policy Forum
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Statement by Scott Lopez, Wellington
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Statement by Henry Hopkins, T. Rowe Price
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Statement by Mary McDermott-Holland, Franklin Portfolio
Associates
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Statement by William A. Schmidt, Kirkpatrick &
Lockhart Nicholson Graham LLP
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Statement by Damon Silvers, AFL-CIO
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Statement by Norman Stein, University of Alabama Law
School
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Written submission by AARP
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Written submission by The Investment Adviser
Association
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Written submission by The Investment Company Institute
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Written submission by North America Securities
Administrators Association, Inc.
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