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Honorable Eugene A. Ludwig
Comptroller of the Currency
250 E Street, S.W.
Washington, DC 20219
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Dear Mr. Ludwig:
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At our last meeting we discussed the Department of Labor's views with
respect to the utilization of derivatives(1) in
the management of a portfolio of assets of a pension plan which is subject
to the Employee Retirement Income Security Act of 1974 (ERISA). This letter
is to provide you with an update of our views in a format which may be of
use to you and your staff.
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ERISA governs private-sector sponsored employee welfare and pension benefit
plans and provides a general framework within which plan fiduciaries are
expected to conduct their investment activities. Under ERISA, a fiduciary
includes anyone who exercises discretion in the administration of an
employee benefit plan; has authority or control over the plan's assets; or
renders investment advice for a fee with respect to any plan assets.(2)
Thus, any entity, including an institution such as a bank, that meets this
functional test with respect to an employee benefit plan sponsored by a
private-sector employer, employee organization, or both, would be considered
a fiduciary under ERISA.
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ERISA establishes comprehensive standards to govern
fiduciary conduct. Among other things, fiduciaries with respect to an
employee benefit plan must discharge their duties with respect to a plan
solely in the interest of the plan's participants and beneficiaries, and
with the care, skill, prudence and diligence under the circumstances then
prevailing that a prudent person acting in a like capacity and familiar with
such matters would use in the conduct of an enterprise of a like character
and with like aims.(3)
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Investments in derivatives are subject to the fiduciary responsibility rules
in the same manner as are any other plan investments. Thus, plan fiduciaries
must determine that an investment in derivatives is, among other things,
prudent and made solely in the interest of the plan's participants and
beneficiaries.
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In determining whether to invest in a particular derivative, plan
fiduciaries are required to engage in the same general procedures and
undertake the same type of analysis that they would in making any other
investment decision. This would include, but not be limited to, a
consideration of how the investment fits within the plan's investment
policy, what role the particular derivative plays in the plan's portfolio,
and the plan's potential exposure to losses. While derivatives may be a
useful tool for managing a variety of risks and for broadening investment
alternatives in a plan's portfolio, investments in certain derivatives, such
as structured notes and collateralized mortgage obligations, may require a
higher degree of sophistication and understanding on the part of plan
fiduciaries than other investments. Characteristics of such derivatives may
include extreme price volatility, a high degree of leverage, limited testing
by markets, and difficulty in determining the market value of the derivative
due to illiquid market conditions.
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As with any investment made by a plan, plan fiduciaries with the authority
for investing in derivatives are responsible for securing sufficient
information to understand the investment prior to making the investment. For
example, plan fiduciaries should secure from dealers and other sellers of
derivatives, among other things, sufficient information to allow an
independent analysis of the credit risk and market risk being undertaken by
the plan in making the investment in the particular derivative. The market
risks presented by the derivatives purchased by the plan should be
understood and evaluated in terms of the effects that they will have on the
relevant segments of the plan's portfolio as well as the portfolio's overall
risk.
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Plan fiduciaries have a duty to determine the appropriate methodology used
to evaluate market risk and the information which must be collected to do
so. Among other things, this would include, where appropriate, stress
simulation models showing the projected performance of the derivatives and
of the plan's portfolio under various market conditions. Stress simulations
are particularly important because assumptions which may be valid for normal
markets may not be valid in abnormal markets, resulting in significant
losses. To the extent that there may be little pricing information available
with respect to some derivatives, reliable price comparisons may be
necessary. After entering into an investment, a plan fiduciary should be
able to obtain timely information from the derivatives dealer regarding the
plan's credit exposure and the current market value of its derivatives
positions, and, where appropriate, should obtain such information from third
parties to determine the current market value of the plan's derivatives
positions, with a frequency that is appropriate to the nature and extent of
these positions.
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If the plan is investing in a pooled fund which is managed by a party other
than the plan fiduciary who has chosen the fund, then that plan fiduciary
should obtain, among other things, sufficient information to determine the
pooled fund's strategy with respect to use of derivatives in its portfolio,
the extent of investment by the fund in derivatives, and such other
information as would be appropriate under the circumstances.
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As part of its evaluation of the investment, a fiduciary must analyze the
operational risks being undertaken in making the investment. Among other
things, the fiduciary should determine whether it possesses the requisite
expertise, knowledge, and information to understand and analyze the nature
of the risks and potential returns involved in a particular derivative
investment. In particular, the fiduciary must determine whether the plan has
adequate information and risk management systems in place given the nature,
size and complexity of the plan's derivatives activity, and whether the plan
fiduciary has personnel who are competent to manage these systems. If the
investments are made by outside investment managers hired by the plan
fiduciary, that fiduciary should consider whether the investment managers
have such personnel and controls and whether the plan fiduciary has
personnel who are competent to monitor the derivatives activities of the
investment managers.
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Plan fiduciaries have a duty to evaluate the legal risk related to the
investment. This would include assuring proper documentation of the
derivative transaction and, where the transaction is pursuant to a contract,
assuring written documentation of the contract before entering into the
contract. Also, as with any other investment, plan fiduciaries have a
duty to properly monitor their investments in derivatives to determine
whether they are still appropriately fulfilling their role in the portfolio.
The frequency and degree of the monitoring will, of course, depend on the
nature of such investments and their role in the plan's portfolio.
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We hope these comments have been helpful. However, if you should have any
further questions or if we can provide any further assistance, please feel
free to contact Morton Klevan at 202.219.9044 or Louis Campagna at 202.219.8883.
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Sincerely,
Olena Berg
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We refer to derivatives in this
letter as financial instruments whose performance is derived in whole
or in part from the performance of an underlying asset (such as a
security or index of securities). Some examples of these financial
instruments include futures, options, options on futures, forward
contracts, swaps, structured notes and collateralized mortgage
obligations.
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See ERISA section 3(21).
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See ERISA section 404(a).
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