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  1. Trust Examination Manual

    Advisory Opinion 2004-05A

    May 24, 2004
    ERISA Sec. 406(a)(1)(A),(D)

    Mr. William R. Charyk
    Arent Fox Kintner Plotkin & Kahn, PLLC
    1050 Connecticut Avenue, NW
    Washington, DC 20036-5339

    Dear Mr. Charyk:

    This is in response to your request for guidance under section 406 of the Employee Retirement Income Security Act of 1974 (ERISA) and section 4975 of the Internal Revenue Code of 1986, as amended (the Code).(1) In particular, you ask whether the execution of a securities transaction between a plan and a party in interest with respect to such plan as defined in ERISA through an alternative trading system (ATS) maintained by Liquidnet, Inc. (Liquidnet) constitutes a prohibited transaction under section 406(a)(1)(A) and (D) of ERISA. In addition, you inquire whether the execution of a securities transaction through the Liquidnet ATS (the Liquidnet System) between a plan and a counterparty that is an affiliate of the fiduciary directing such trade on behalf of the plan also violates section 406(b) of ERISA.

    You write on behalf of Liquidnet, a registered broker/dealer that maintains the Liquidnet System. The Liquidnet System is an "alternative trading system," as defined in Rule 300(a) of Regulation ATS under the Securities Exchange Act of 1934, as amended. You also represent that all of Liquidnet’s approximately 200 subscribers are large institutional investors that individually manage, on average, approximately $31 billion of equity assets. You note that these subscribers, none of which are affiliated with Liquidnet, often act as named fiduciaries, investment managers, or provide other services to employee benefit plans.

    You state that Liquidnet was created to facilitate the trading of “blocks” of equity securities. In this regard, since its inception in 2001, more than three billion shares of equity securities have been traded over the Liquidnet System pursuant to trade sizes that have averaged approximately 44,000 shares. You state that the total value of the shares traded through the Liquidnet System approximated $61 billion as of August 29, 2003.

    You state that subscribers to Liquidnet may trade U.S., U.K., French, German, Netherlands, and Swiss equity securities through the Liquidnet System. In this regard, you state that the Liquidnet System: (1) interfaces with the order management systems of Liquidnet’s subscribers; and (2) identifies, with respect to a particular security, each Liquidnet subscriber that has an interest in buying the security and each Liquidnet subscriber that contemporaneously has an interest in selling the security. You state that each Liquidnet subscriber indicates to the Liquidnet System its interest in buying or selling various securities. If one subscriber indicates to the Liquidnet System an interest in buying a certain security that a different subscriber has independently indicated to the Liquidnet System an interest in selling, the Liquidnet System notifies both subscribers that a transaction opportunity exists.(2) You note that the Liquidnet System does not disclose the identity of either subscriber to the other. The two subscribers may then negotiate; through their respective computer systems; both the price and the quantity of the security. Accordingly, you state that the Liquidnet System enables subscribers to engage in an anonymous, no obligation, one-on-one, real-time negotiation (a subscriber must terminate its current negotiation with another subscriber before engaging in a new negotiation with a different subscriber).

    You state that multiple Liquidnet subscribers may have an interest in buying (or selling) a security that a different Liquidnet subscriber has an interest in selling (or buying). Where, for example, the Liquidnet System identifies that multiple subscribers have an interest in buying a security that a different subscriber has an interest in selling, the Liquidnet System provides the selling subscriber with an electronic listing of the anonymous subscribers interested in buying. You note that once a subscriber is provided with such a listing, the subscriber may thereafter negotiate with any or all of the subscribers on the list. You state that the Liquidnet System currently determines the order of a multiple subscriber listing by comparing the quantities they have posted to the quantity posted by the single contra-side subscriber. The subscriber posting a quantity that is nearest to the quantity posted by the single contra-side subscriber is placed first on the list. The remaining order is determined in the same fashion.(3) You state that the Liquidnet System's trading rules, which are distributed to all subscribers, contains a disclosure that describes how multiple potential negotiating subscribers will be ordered.

    You represent that trades entered into pursuant to the Liquidnet System are executed on a “blind” basis. In this regard, you state that, during the entire execution and settlement processes, subscribers interact with each other pursuant to policies and rules designed to ensure anonymity. You represent that the Liquidnet System, never discloses the identity of a subscriber to any other. In addition, all physical transfers of equity securities and cash are made between an independent clearing firm, Bear, Stearns Securities Corp. and the buyer’s and seller’s respective custodians. Therefore, the identities of the parties to a trade will not be revealed to the parties during the clearing process.

    You state that: given the number and type of Liquidnet subscribers; the large number of trades executed on Liquidnet on a daily basis; and the fact that such trades are executed and settled pursuant to rules, procedures and software designed to ensure anonymity; it is expected that the parties to a transaction engaged in through the Liquidnet System will not know, at any time, the identity of each other.(4) Accordingly, it is possible for a subscriber, in its capacity as a fiduciary with respect to a plan, to unknowingly buy/sell a security on behalf of the plan through the Liquidnet System from/to a Liquidnet subscriber that is a party in interest to the plan.

    Further, you note that although a subscriber cannot execute a securities transaction with itself through the Liquidnet System (i.e., as both the buyer and seller), it is possible for a plan fiduciary to direct a trade through the Liquidnet System whereby the Liquidnet subscriber that is the counterparty to the plan is an affiliate of such fiduciary. You state that two affiliates may request that Liquidnet "block" negotiations between the two entities. However, you note that a Liquidnet subscriber may not be aware that an affiliate thereof is also a Liquidnet subscriber.

    Section 3(14)(A) and (B) of ERISA defines the term “party in interest” as meaning, as to an employee benefit plan, any fiduciary (including, among others, a trustee) of an employee benefit plan; and a person providing services to such plan. ERISA section 3(21)(A) provides that a person is a fiduciary with respect to a plan to the extent that (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, (ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of the plan, or has any authority or responsibility to do so, or (iii) he has any discretionary authority or responsibility in the administration of such plan.

    Section 406(a)(1)(A) of ERISA prohibits a fiduciary with respect to a plan from causing the plan to engage in a transaction if he or she knows or should know that the transaction constitutes a direct or indirect sale or exchange, or leasing, of any property between the plan and a party in interest. Section 406(a)(1)(D) of ERISA provides that a fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he or she knows or should know that such transaction constitutes a direct or indirect transfer to, or use by or for the benefit of, a party in interest, of any assets of the plan. Section 406(b)(1) of ERISA provides that a fiduciary with respect to a plan shall not deal with the assets of the plan in his or her own interest or for his or her own account. Section 406(b)(2) provides that a fiduciary with respect to a plan shall not in his or her individual or in any other capacity act in any transaction involving the 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.

    With respect to purchases and sales of equity securities, we note that the Conference Report accompanying ERISA states that:

    In general, it is expected that a transaction will not be a prohibited transaction (under either the labor or tax provisions) if the transaction is an ordinary “blind” purchase or sale of securities through an exchange where neither buyer nor seller (nor the agent of either) knows the identity of the other party involved. In this case, there is no reason to impose a sanction on a fiduciary (or party-in-interest) merely because, by chance, the other party turns out to be a party-in-interest (or plan). H.R. Rep. 93-1280, 93rd Cong., 2d Sess., 307 (1974).

    As you noted, Liquidnet matches purchase and sell orders from its clients and gives purchasers and sellers the opportunity to negotiate a trade based on price and volume. The number of subscribers and the trading procedures assure a party’s anonymity, unless the party wishes to identify itself to the counter-party. In our view, transactions executed through Liquidnet’s trading procedures for the execution of transactions, that are designed to permit anonymous negotiations without identifying the parties, function in a manner similar to the operation of an exchange. Accordingly, based on your representations, it is our further view that “blind” transactions executed pursuant to such procedures would not, in themselves, constitute prohibited transactions under section 406(a)(1)(A), 406(a)(1)(D), 406(b)(1) or 406(b)(2) of ERISA.

    The Department notes, however, that a transaction effectuated through the Liquidnet System will not be considered "blind” if, prior to the execution of such transaction, the plan fiduciary responsible for the plan's engagement in the transaction knew, or had reason to know, the identity of the counterparty to such transaction. Given the ability of parties to a transaction to disclose their identities to each other, persons trading on behalf of employee benefit plans should be particularly careful to make sure the transaction is truly blind. Moreover, these determinations assume that such purchase and sale transactions did not arise in connection with any arrangement, agreement, or understanding designed to benefit the fiduciary (including an affiliate thereof) or any other party in interest to the plan.

    In addition, with respect to the arrangement and transactions described above, ERISA's general standards of fiduciary conduct apply to: (i) the determination to buy or sell a particular equity security (and, in addition, the determination as to the appropriate purchase or sale price for such security); and (ii) the determination as to which trading system should be used to assist with the purchase or sale of equity securities.(5) In this regard, as noted above, section 404 of ERISA requires a fiduciary to discharge his duties respecting a plan solely in the interest of the plan's participants and beneficiaries. This section also requires that a plan fiduciary act prudently and for the exclusive purpose of: providing benefits to plan participants and their beneficiaries; and defraying reasonable expenses of administering the plan. Accordingly, plan fiduciaries that subscribe to Liquidnet must consider the costs associated with the use of alternative trading systems as well as the potential revenue returns, discounts, and other benefits that result from the continuing use of particular alternative trading systems over other similar services.

    Further, prior to a plan fiduciary’s decision to execute a securities transaction through Liquidnet, the plan fiduciary (as a subscriber or an affiliate of a subscriber) should determine whether any existing or potential conflicts of interest or prohibited transactions under ERISA would interfere with the proper exercise of any of the fiduciary’s responsibilities under section 404 of ERISA, including the duty to act solely on behalf of the plan.

    This letter constitutes an advisory opinion under ERISA Procedure 76-1 (41 Fed. Reg. 36281, August 27, 1976). Accordingly, this letter is issued subject to the provisions of the procedure, including section 10 relating to the effect of advisory opinions. The opinion only relates to the specific issues raised by your request. For example, you have not asked and the Department is expressing no opinion with respect to the fees and other compensation received by persons engaging in transactions on the Liquidnet System on behalf of plans.

    Louis Campagna
    Chief, Division of Fiduciary Interpretations
    Office of Regulations and Interpretations


    Under Reorganization Plan No. 4 of 1978, 43 FR 47713 (5 U.S.C. App. 1 [1996]), the authority of the Secretary of the Treasury to issue rulings under section 4975 of the Code has been transferred, with certain exceptions not here relevant, to the Secretary of Labor. The Secretary of the Treasury is bound by interpretations of the Secretary of Labor pursuant to such authority. Therefore, references in this letter to specific sections of ERISA should be read to refer also to the corresponding sections of the Code.
  2. Accordingly, you state that Liquidnet does not "solicit" subscriber interest with respect to the buying or selling of securities (i.e., once a subscriber notifies Liquidnet that it has an interest in buying or selling a security, the Liquidnet System does not thereafter broadcast that interest to all of the other Liquidnet subscribers).
  3. You state that in the future, the percentage of successful negotiations attributable to each respective subscriber may also affect the ordering of a multiple subscriber list.
  4. You note, however, that subscribers using the system to negotiate a securities transaction may "chat" with each other. In this regard, you state that although the Liquidnet System does not disclose the identities of negotiating subscribers to each other, two such subscribers may electronically correspond to each other, without restriction as to content, through the Liquidnet System as part of the negotiation. You note that this type of correspondence is reviewed and retained by Liquidnet.
  5. Whether, in light of all the facts and circumstances, a purchase or sale of securities or the use of a particular service provider satisfies the fiduciary responsibility provisions of ERISA is an inherently factual question as to which the Department generally will not opine. See section 5.01 of ERISA Procedure 76-1, 41 Fed. Reg. 36281 (Aug. 27, 1976).

Last Updated 04/02/2008

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