Liquidity Issues For Plan Fiduciaries Relating To Securities Lending Or Stable Value Funds

Tuesday, June 30, 2009 - 01:00

Plan fiduciaries are currently facing various liquidity issues in connection with pension and 401(k) plans. There are two circumstances, in particular, where plan administrators are dealing with new and unexpected concerns: securities lending programs and stable value funds. Plan administrators have been surprised to learn that, in the current economic climate, what were once considered safe investments, may actually be quite volatile. As discussed in greater detail below, plan administrators should be aware of the current issues surrounding securities lending programs and the "stability" of stable value funds.

What Is A Securities Lending Program?

Historically, investment managers have sought to be "fully invested," to maximize returns for their investors (and their performance fees), but with reserves of cash and cash equivalents to meet redemptions in the ordinary course. Many of these investments have been relatively long-term, where positions have been established to meet forecasted needs rather than trading gains based on short-term changes in value. Securities lending programs have historically been employed to generate additional income on securities portfolios, especially these kinds of positions. Typical investment management agreements authorize the investment managers to engage in securities lending. In securities lending, the investment manager directs the plan custodian to deliver ("lend") securities to counterparties in exchange for collateral (typically cash or government securities) in an amount or with a value that exceeds by a small margin the value of the loaned securities as of the date of the loan. The counterparties pay interest on the value of the loaned securities, and typically the plan and investment manager share in the interest earned. The collateral in turn is invested in low risk, highly liquid investments, such as Treasury bills or money market instruments. Until recently, securities lending has been understood to be a conservative investment mechanism to increase returns on investments and offset fees.

The recent crisis in the financial markets has revealed flaws in previous assumptions, theories and understandings. This uncertainty has led investors to seek to redeploy assets to more secure investments. Simultaneously, the economic recession has led to an increase in redemptions as investors seek funds to meet current needs in the face of income declines. Together with the redeployment mentioned above, funds, including those in pension and 401(k) plans, are facing unprecedented liquidity demands to meet redemptions. In addition, plans that have engaged in securities lending have been exposed to extraordinary counterparty risk, both inability to perform timely as well as inability to perform at all (e.g., Lehman Bros.), and have been left with collateral investments that declined in value or experienced sharp mark-to-market losses related to illiquidity. When plans seek to withdraw or redeploy cash to meet such demands or reduce such risks, the investment manager who has loaned securities may only be willing to redeem based on current market value of the collateral or to make in-kind distributions. The managers maintain that valuations will return to normal levels and the restrictions are intended to protect all investors in the fund from losses due to precipitous redemptions as well as consequences of being the last one to redeem. These circumstances pose important issues for plan fiduciaries.

What Are Stable Value Funds?

Stable value funds are capital preservation investment options, which are invested in a diversified fixed income portfolio and are protected against interest rate volatility by contracts from banks and insurance companies. Originally, stable value funds relied heavily on guaranteed investment contracts ("GICs"). A GIC is a contract between an insurance company and a plan that guarantees a fixed rate of return. Today, the majority of stable value assets are invested in synthetic GICs or wrapped bonds, which are usually short-term bonds that are bound by insurance wrappers. If a stable value fund falls below the rate of return set by the wrapper, then the insurer pays the difference, but if the fund has gains in excess of the wrapper's return, then the fund pays the insurer the difference. Stable value funds are offered in about 50% of all 401(k) plans, $520 billion has been invested in stable value funds through 138,000 defined contribution plans, and stable value funds are one of the most widely used investments by 401(k) investors who on average allocate roughly 15% to 20% of their 401(k) assets to stable value funds.1

While stable value funds are considered safe investments, they too are subject to market volatility and have experienced lower returns than in previous years.Stable value funds have also been affected by credit downgrades of GIC issuers and the underlying securities, and plan administrators may be concerned with the creditworthiness of the insurers that wrap the funds. For example, AIG, who wraps many stable value funds, received extensive publicity for its financial difficulties. Some stable value funds include liquidity provisions that allow employer-initiated withdrawals to be delayed by up to 12 months, making the investments illiquid.

ERISA Fiduciary Duties

Under ERISA, a person is a fiduciary to the extent he (a) 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, (b) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or (c) has any discretionary authority or discretionary responsibility in the administration of such plan.2

Plan administrators and their investment managers are considered fiduciaries under ERISA and must discharge their duties solely in the interest of the participants and beneficiaries, for the exclusive purpose of providing benefits to them, with the care, skill, prudence and diligence of a prudent person, and by diversifying the plan's investments to minimize the risk of large losses.3A fiduciary is expected to give "appropriate consideration" to the facts and circumstances that the fiduciary knows or should know are relevant to the particular investment.4The concept of "appropriate consideration" includes a determination by the fiduciary that a particular investment, or investment course of action, is reasonably designed to further the purposes of the plan, taking into consideration the risk of loss and the opportunity for gain associated with such investment. Failure to adhere to this standard of care may result in a breach of fiduciary duty under ERISA.

Current Fiduciary Duty Litigation

Plan administrators may bring a breach of fiduciary duty claim against their investment managers related to securities lending or stable value funds, or may find themselves the subject of such lawsuit by plan participants.

At least three class-action lawsuits have recently been filed by plan administrators against investment managers in connection with losses incurred as a result of securities lending programs.5In these cases, the plan administrators assert that the investment managers breached their fiduciary duties of prudence, loyalty and exclusive purpose under ERISA by engaging in securities lending for their own benefit and in an imprudent manner, creating an unreasonable risk of loss to the plans. The complaints filed note that collateral pools should be invested in low-risk, highly liquid instruments, such as U.S. treasuries, but the defendant investment managers invested in high-risk, illiquid instruments presumably to yield a greater return. The complaints assert that the investment managers were entitled to profits from the invested collateral and additional fees, but did not bear any risk of investment loss, thereby providing an incentive to take greater risk than was appropriate. Although the outcomes of these lawsuits are unknown, courts will likely focus on the process of selecting the investments, rather than the outcome (i.e., loss of value) in analyzing whether there is a breach of fiduciary duty under ERISA.6

While we are not aware of any pending actions asserting a breach of ERISA fiduciary duty claim relating to stable value funds, plan administrators should note that, as with securities lending programs, stable value funds may also lead to such lawsuits. For example, Chrysler LLC and its investment manager, Dwight Asset Management, may be the subject of a lawsuit based on allegations that they failed to manage the assets of Chrysler's 401(k) plan prudently by investing the stable value fund assets in risky, highly leveraged bonds or in insurance company contracts tied to mortgage-backed securities. Lawsuits of this type will likely be brought as a class action on behalf of plan participants.

What Is A Plan Administrator To Do?

Most importantly, plan administrators should be aware of the recent issues with securities lending and determine if they have any exposure. If any of the plan's investment managers have discretion to lend securities, it is prudent to analyze the stability and liquidity of the collateral pool. If a plan administrator becomes aware that there are restrictions on redemptions or withdrawal of the plan's account, the plan administrator should inquire into how the collateral was invested. If it is determined that the collateral reinvestment was not prudent, the plan may have a claim for breach of fiduciary duty against the investment manager.

Another option plan administrators should consider is withdrawing funds. As outlined above, many investment managers have placed restrictions on full redemption, but an analysis of what is negotiable and the benefits of earlier redemption should be undertaken. Plan administrators may also consider doing nothing and essentially "riding out" the volatile market conditions. If the plan can only get the current market value upon exiting the securities lending program, it may be worthwhile to wait until the market has stabilized and investments have returned to full value before withdrawing funds. Regardless of the approach taken, plan administrators should consider the rules and benefits for allowing securities lending going forward.

Similarly, with respect to stable value funds, plan administrators should consider their alternatives such as investing in a money market fund. Plan administrators should compare the potential returns against the greater risks between stable value funds and money market funds and evaluate whether the potential for greater returns with stable value funds is worth the risk they may carry. In addition, as with securities lending programs, plan administrators should discuss alternatives or approaches to withdrawal with the investment managers. After careful analysis, plan administrators may decide to maintain plan assets in stable value funds; even with the risks described above, they may still be one of the lower risk investment options available. 1 Stable Value Investment Association Frequently Asked Questions, http://www.stablevalue.org/help/ faq_main.asp (last visited June 10, 2009).

2See ERISA § 3(21)(A)(i).

3See ERISA § 404(a)(1).

4See 29 C.F.R. § 2550.404a-1(b)(1).

5See e.g., Complaint, Fishman Haygood Phelps Walmsley, Willis & Swanson, L.L.P. v. State Street Corp., No.

10533 (D.Mass Apr. 7, 2009); Complaint, Exxonmobil Savings Plan v. Northern Trust Investment, No. 1934 (N.D. Ill Apr. 1, 2009); Complaint , Board of Trustees of the AFTRA Retirement Fund v. JPMorgan Chase Bank, N.A., No. 00686 (S.D.N.Y Jan. 23, 2009).

6 Courts have held that the prudence analysis should focus on the process of the decision making rather than the outcome, stating that the test is "whether the individual trustees, at the time they engaged in the challenged transactions, employed the appropriate methods to investigate the merits of the investment and to structure the investment." Donovan v. Mazzola, 16 F.2d 1226, 1231 (9th Cir. 1983).

Richard S. Chargar is a Partner in the Stamford, Connecticut office of Kelley Drye & Warren LLP. Mr. Chargar is the Co-Chair of the Employee Benefits and Executive Compensation practice group. M. Ridgway Barker is a Partner in the Stamford, Connecticut office of Kelley Drye & Warren LLP. Mr. Barker is the Chair of the Corporate Finance and Securities practice group . Sandra Costa, an Associate at the firm, assisted in the preparation of this article.

Please email the authors at rchargar@kelleydrye.com or mrbarker@kelleydrye.com with questions about this article.