The Department of Labor (“DOL”) recently issued Advisory Opinion 2013-01A (the “Advisory Opinion”) regarding the application of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), to “cleared swap” transactions under the Dodd-Frank Wall Street Reform and Consumer Protection Act. This Memorandum outlines the holdings of the Advisory Opinion relevant to investment managers of ERISA plan separate accounts or private investment funds that are subject to Title I of ERISA (such accounts and funds are collectively referred to herein as “Plan Asset Vehicles”).

Collateral Is Not “Plan Assets”

The Advisory Opinion held that the collateral posted by a Plan Asset Vehicle in connection with cleared swap transactions is not a “Plan Asset” for the purposes of Title I ERISA; rather, the Plan Assets are the rights of the Plan Asset Vehicle embodied in the written agreement. In reaching this conclusion, the DOL reaffirmed its 1982 advisory opinion (A.O. 82-49A) where the DOL determined that the margin in the context of futures contracts is not a Plan Asset. The DOL also confirmed its long standing position that, except as provided under regulations with respect to a plan’s investment in other entities and with respect to participant contributions, the assets of an ERISA plan generally are to be identified on the basis of ordinary notions of property rights.

ERISA Status of Clearing Entities

The Advisory Opinion held that neither a central counterparty nor a clearing member is an ERISA “fiduciary” with respect to a Plan Asset Vehicle by virtue of its selling posted collateral, closing out swap positions, or exercising its rights in the event of default or other contractually specified events in a typical cleared swap agreement with a Plan Asset Vehicle. Although not an ERISA fiduciary, the DOL held that a clearing member would be a “party in interest” under ERISA by virtue of services it provides to a Plan Asset Vehicle under the agreement with a Plan Asset Vehicle. Therefore, a Plan Asset Vehicle needs to rely on an exemption from the prohibited transaction provisions under ERISA Section 406(a) when entering into the written documents authorizing the cleared swap transactions.

Availability of the QPAM Exemption

The Advisory Opinion specifically cited to the Prohibited Transaction Class Exemption 84-14, as amended (the “QPAM Exemption”), as available to exempt the prohibited transactions in a typical cleared swap arrangement. Among other requirements of the QPAM Exemption¹, the QPAM must make the investment decisions and negotiate the terms of the transactions to be entered into by a Plan Assets Vehicle (e.g., the provision of services or the exchange of property in connection with cleared swap transactions). However, since a typical agreement with a clearing member authorizes the clearing member to engage in certain risk reducing transactions in the event of default or other contractually specified events (e.g., liquidations, close-out transactions), the QPAM would not be directing these risk reducing transactions taken by the clearing member. In addressing this concern, the Advisory Opinion cited the preamble of the QPAM Exemption describing “subsidiary transactions”. Under the QPAM Exemption, exemptive relief is available for subsidiary transactions “if the QPAM reviews the terms of the subsidiary transactions as part of its determination that the [primary] transaction, as a whole, is prudent and otherwise in the best interests of plan participants”. The Advisory Opinion concluded that the liquidation and close-out transactions are subsidiary transactions and, therefore, are exempt under the QPAM Exemption if the agreement negotiated by a QPAM with a clearing member contains sufficient terms with respect to the subsidiary transactions so that the potential outcomes of these transactions are reasonably foreseeable to the QPAM when entering into the agreement. Accordingly, the QPAM should consider documenting its evaluation of the terms of the agreement with respect to the Plan Asset Vehicle’s rights, benefits and obligations in connection with the cleared swap transactions and, specifically, in connection with any remedial action, the likelihood for such events to occur and the potential economic exposure to the Plan Asset Vehicle.

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If you have any questions regarding this memorandum, please contact S. John Ryan at (212) 574-1679 or Michael O’Brien at (212) 574-1505.

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¹ To qualify as a QPAM, the investment manager must: (i) be registered under the Investment Advisers Act of 1940, (ii) have total client assets under its management and control in excess of $85,000,000 as of the last day of its most recent fiscal year, (iii) have shareholders’ or partners’ equity in excess of $1,000,000 as shown in the most recent balance sheet, and (iv) acknowledge in writing its fiduciary status with respect to each ERISA plan invested in, or establishing, the Plan Asset Vehicle. For a comprehensive list and discussion of other requirements of the QPAM Exemption, please contact an ERISA attorney listed in this memorandum.