The Department of Labor resolved key issues related to cleared swaps transactions in a recent advisory opinion. The opinion concludes that margin posted by an employee benefit plan in connection with a cleared swap is not a “plan asset” for purposes of ERISA, and that a Clearing Member does not act as a fiduciary of the plan when the Clearing Member exercises discretionary account liquidation rights upon the plan’s default. The opinion also provides guidance on prohibited transaction issues raised by the clearing process.
A “swap” generally refers to a transaction in which two parties exchange streams of payment based on a notional principal amount. For example, one party might pay interest on $1 million notional at a fixed rate of interest, while the other party pays interest at a floating rate tied to the prime rate. If the floating rate exceeds the fixed rate, the second party will make payments to the first party, and vice versa. Many employee benefit plans engage in swap transactions as part of their investment program.
The Dodd-Frank Wall Street Reform and Consumer Protection Act requires that certain swap transactions be executed through a “Clearing Member” that clears the swap through a central counterparty (“CCP”). An end-user, such as an employee benefit plan, identifies a desired transaction with a swap dealer to be submitted for clearing. When the CCP accepts the swap, the original swap is extinguished and two equal and opposite transactions are substituted, one between the employee benefit plan and the CCP, and the other between the CCP and the swap dealer. A Clearing Member guarantees the plan’s and the swap dealer’s obligations. As a result of the clearing process, the swap dealer is not exposed to credit risk from the plan and the plan is not exposed to credit risk from the swap dealer, since both are now counterparties to the CCP, which also guarantees the transactions.
In order to secure the Clearing Member’s and the CCP’s guarantee of their obligations, the employee benefit plan and the swap dealer must provide collateral, which is referred to as “margin.” The margin is held by the Clearing Member or the CCP during the period of the swap, and may be used by the CCP to satisfy losses and pass on gains to the swap counterparties. Before the Labor Department issued its advisory opinion, it was unclear whether the Department would treat margin posted by an employee benefit plan in a cleared swap transaction as a “plan asset.” If the margin was treated as a plan asset, the Clearing Member would be a fiduciary of the plan and would be at risk of engaging in prohibited transactions or breaches of fiduciary duty in connection with its handling of the margin.
The Labor Department had issued an advisory opinion in 1982 concluding that margin posted to secure cleared futures transactions was not a plan asset; but Department officials had warned publicly that the futures opinion was limited to its facts and might not extend to cleared swaps. Nevertheless, the recent advisory opinion applies the same reasoning to margin posted to secure cleared swap transactions. The opinion concludes that the margin is “in the nature of a performance bond” assuring that the plan will meet its contractual obligations and is not an asset of the plan that posts the margin. The Labor Department was careful to limit its analysis and conclusion to margin posted as part of the clearing process for swaps. Accordingly, the advisory opinion does not answer the longstanding question whether collateral posted under credit support agreements for over-the-counter swaps is a plan asset.
If the employee benefit plan defaults on its obligations under the swap, the Clearing Member must make good to the CCP, and the CCP must make good to the swap dealer. The agreement between the Clearing Member and its customer permits the Clearing Member to liquidate the customer’s positions by entering into certain offsetting or risk-reducing transactions if a default occurs or is reasonably foreseeable.
Clearing Members were concerned that they would be viewed as fiduciaries of their employee benefit plan customers when they exercised these liquidation rights. The Labor Department recognized, however, that the clearing process could not operate as intended if the Clearing Member was considered a plan fiduciary in this circumstance, since the Clearing Member could not act solely in the plan’s interest but instead must act to protect itself, the CCP, and the clearing process. Accordingly, the advisory opinion confirms that a Clearing Member will not become a plan fiduciary solely by exercising its contractual liquidation rights in the event of (or in anticipation of) an employee benefit plan customer’s default.
The Labor Department also considered whether the clearing process could result in a prohibited transaction under ERISA. The opinion concludes that a CCP does not provide services to the plan and thus is not a party in interest for purposes of the prohibited transaction rules merely by virtue of its role in the clearing process. In contrast, the opinion concludes that a Clearing Member does provide a service to the plan when it acts on behalf of the plan in a cleared swap transaction. As a result, the Clearing Member is a party in interest with respect to the plan, and certain actions of the Clearing Member (such as the guarantee of the plan’s obligation to the CCP) could result in a prohibited transaction. The opinion notes, however, that these potential prohibited transactions can be avoided if the plan is represented by a qualified professional asset manager (“QPAM”) when entering into the swap transaction.
The advisory opinion provides welcome assurances to employee benefit plans that enter into cleared swap transactions and to the other parties that participate in the clearing process. Plan fiduciaries should note, however, that the advisory opinion identifies a number of precautions employee benefit plans should take when they enter into cleared swap transactions, including provisions that employee benefit plans should include in their agreements with Clearing Members. Plan fiduciaries should review the advisory opinion carefully and follow it closely in order to avoid potential liability under ERISA for cleared swap transactions.