Advisory Opinion 1999-16A

Dear Ms. Occhino:

This is in response to your request for an advisory opinion concerning whether the payment of certain performance-based compensation to Mount Lucas Management Corporation (Mount Lucas) by employee benefit plan clients would violate section 406(b) of the Employee Retirement Income Security Act of 1974 (ERISA) or section 4975 of the Internal Revenue Code of 1986 (the Code).⁽¹⁾

You represent that Mount Lucas is a registered investment adviser under the Investment Advisers Act of 1940, a registered commodity trading advisor (CTA), and a registered commodity pool operator under the Commodity Exchange Act. Mount Lucas offers investment management services to a wide range of institutional clients, including pension and profit-sharing plans qualified under Code section 401(a) and subject to ERISA. Mount Lucas acts as investment manager for individual plan accounts (Accounts), as the general partner of a limited partnership available for plan asset investments in amounts of not less than $2,000,000, and as the manager of a business trust that is likewise available for plan asset investments.

By written agreement with client plans, Mount Lucas invests certain plan assets in commodity futures and forward contracts, and in options on commodities and commodity futures contracts. For this purpose, Mount Lucas directs the trading itself and may also employ the services of other CTAs.⁽²⁾ Mount Lucas offers both passive and active management of client funds.⁽³⁾ For actively managed Accounts of sufficient size (in excess of $6,000,000), Mount Lucas may recommend to the plan fiduciary that additional, independent CTAs be retained by Mount Lucas on behalf of the plan to the extent Mount Lucas determines that such additional services are necessary to satisfy Mount Lucas' stated diversification policy.⁽⁴⁾ In such situations, Mount Lucas recommends specific CTAs to the plan fiduciary that it believes are suited to the needs of the Account. All decisions regarding the appointment of additional CTAs are made by the plan fiduciary. Mount Lucas and the CTAs make the actual investment decisions on behalf of the Accounts for which they are retained and have full discretionary authority over the trading of the plan assets allocated to their control. Where additional CTAs have been appointed, Mount Lucas allocates investment authority over the assets in Accounts among the CTAs and monitors, supervises, and recommends replacement of the CTAs. Mount Lucas pays the CTAs for their services out of the fees that Mount Lucas receives from the plans. All brokers utilized by Mount Lucas and the CTAs in executing trades are independent of Mount Lucas and the CTAs.

The assets in Accounts for which Mount Lucas has investment authority consist principally of futures and option contracts that are traded on recognized futures exchanges regulated by the Commodity Futures Trading Commission (CFTC), the value of which can be readily determined by reference to their settlement prices determined at the close of trading each business day on the particular exchange. You represent that each exchange or its clearinghouse has established rules regulating the determination of settlement prices. Settlement prices are thus objectively determined by third parties independent of Mount Lucas. Settlement prices are available from many independent, widely available sources, including the Wall Street Journal and the New York Times, as well as data services such as CGQ, Quotron and Reuters. You further represent that, while a small number of futures and options contracts covering the same or similar commodities are traded on more than one exchange, contracts from different exchanges are generally not fungible and cannot be used to offset each other. Therefore, contracts that are traded on one exchange can only be valued and offset on that exchange.⁽⁵⁾

You represent that an Account may also include foreign currency forward contracts that are traded in the interbank market, which is estimated to have a volume of approximately $300 billion a day. The interbank market is a 24-hour worldwide market with participants including major commercial banks, investment banks, securities and commodities brokers and dealers, pension funds, insurance companies, and multinational companies. In addition to quotations regarding such contracts received directly from market participants, services such as Reuters and Telerate provide continuous and reliable market quotations on these foreign currency forward contracts. You represent that it is Mount Lucas' intention and understanding that, with respect to plan Accounts, the plan's custodian (generally, the plan trustee, who is independent of Mount Lucas and any of its affiliates) can and does value such contracts on the basis of widely disseminated quotations available from independent services, such as a particular "page" offered by Reuters and Telerate that provides bid and ask quotes on a particular currency by major banks which regularly trade such currencies. The particular source of the valuation and the timing of the valuation are expressly agreed upon by a plan trustee and Mount Lucas and set forth in writing at the time Mount Lucas' services are obtained for an Account. Foreign currency forward contracts are thus valued by third parties independent of Mount Lucas. In no event will Mount Lucas value such contracts. Mount Lucas does not invest the assets of any Account in any contracts that are not of sufficient size to be traded on the interbank market⁽⁶⁾ or that are not capable of being readily and objectively valued by the independent plan fiduciary by reference to established market settlement prices and quotations.

You further represent that, for Mount Lucas' services, a client plan may be charged, subject to arms-length negotiation, the following basic fees: (1) a monthly or quarterly fixed fee, negotiated at arm's length with each client plan, that ranges from .50 to 1.50% per annum of the value of the plan's net assets under management (this fee may decline as a percentage as the amount of the plan's assets under Mount Lucas' management increases); and (2) the performance fee discussed below. The other expenses borne by client plans are the actual brokerage costs charged by brokerage firms not affiliated with Mount Lucas (estimated to range from 2.40% to 3.20% per year of the value of the plan assets under management). You represent that Mount Lucas believes that its fees are lower than the average fees charged by other registered commodity trading advisors for the provision of similar services. Mount Lucas also believes that the total amount of fees charged to any client plan, including any performance fees, is not more than reasonable compensation for the services rendered to that plan by Mount Lucas.

For some clients and some trading programs, Mount Lucas' fees include an annual performance fee. Mount Lucas offers such a performance-based fee arrangement only to plans with assets of at least $50,000,000, and no such plan is permitted to place more than ten percent of its total assets under Mount Lucas' management. You represent that Mount Lucas' performance fee arrangements comply in all material respects with the requirements of Investment Advisers Act Rule 205-3 of the Securities and Exchange Commission (SEC Rule 205-3), governing performance compensation arrangements of investment advisors, and with all applicable CFTC rules. Client plans must pay the fixed fee and brokerage costs regardless of whether Mount Lucas earns a performance fee for any performance period (generally the calendar year). Any earned performance fee is paid on a pre-specified, agreed-upon date at the end of the annual performance period, which is generally December 31 of each year. Where Mount Lucas retains independent CTAs for an Account, Mount Lucas receives all fees and distributes to the selected CTAs their earned portions as determined under a preestablished written formula. That formula provides that performance fees are paid to the CTAs only in the event that the net performance of the Account results in a performance fee being paid to Mount Lucas.

In the case of client plans that choose a performance-fee arrangement, the performance fee is established, through arm's-length negotiation, as a specified percentage of the amount by which the "cumulative profits" (Cumulative Profits)⁽⁷⁾ of a plan client's Account at the end of a performance period exceed the highest level of Cumulative Profits for that Account as of the end of any prior performance period. The performance fee will be paid only in the event that the combined performance of Mount Lucas and any CTAs results in a "new high level" of Cumulative Profits relative to the Cumulative Profits at the end of any prior annual performance period.⁽⁸⁾ A "new high level" of Cumulative Profits is reached under the contract only when the Cumulative Profits for a client's Account for a performance period are higher than the Cumulative Profits for any previous performance period. Under this formula, any losses suffered by an Account as of the end of any prior annual performance period under the particular investment management agreement with Mount Lucas must be recouped before any new performance fee may be earned.

Under the terms of some of its performance-fee arrangements, Mount Lucas is entitled to a performance fee only if the Cumulative Profits of an Account, in addition to exceeding the highest level of prior Cumulative Profits for that Account, also exceeds a preestablished "hurdle rate." The "hurdle rate" is selected by the plan's independent fiduciary, but in most cases is the MLM Index Profit (the Index Profit), a figure that is derived from the MLM Index (the Index).

You represent that use of the Index Profit to establish the "hurdle rate" that determines, in part, whether a performance fee has been earned assures objectivity because of the nature of the calculations on which the Index Profit is based. You explain that the Index is an index of commodities futures contracts that is designed to reflect the way that commodity traders, including Mount Lucas, earn profits with respect to a broadly diversified managed futures portfolio. The Index, which is owned and managed by Mount Lucas, is based on the daily closing prices of contracts for the 25 largest U.S. futures markets in different commodities.(9) A determination as to which markets are to be included in the Index is made in the December preceding the start of each year, and markets are not added or deleted from the Index during the year. For each market included in the Index, four delivery months are used for the return calculation. In general, the delivery months included are "nearby" -- i.e., those due to expire as of the next, or second next, but are not in, the physical delivery period, as specified by the sponsoring exchange. Thus, the selection of the markets to be included in the Index each year is done on a purely objective basis, and the calculation of the return for each market is a mechanical operation. You further represent that the Index is published daily by Bloomberg Financial Services on its financial data service.

The Index is used, under Mount Lucas performance-fee arrangements, to determine "Index Profit" in the following manner. Each month the beginning assets of each Account are multiplied by that month's "Index rate of return," and the results are summed over the annual performance period. For this purpose, a month's "Index rate of return" equals the "risk-free rate"⁽¹⁰⁾ for the assets under consideration for that month, plus the arithmetic (i.e., non-weighted) average of the rates of return of the 25 individual markets.⁽¹¹⁾ The sum of the twelve monthly results of this computation during the performance period equals the Index Profit for that Account for that performance period.

You have represented that the determination of whether a performance fee has been earned is made on an agreed-upon specified date at the end of the annual performance period, which is generally December 31. To make that determination, the initial Account value for the year, the net trading income (or loss), and the interest income attributable to that Account are added together. The fixed management fees charged to that Account are calculated as a percentage of this total. The fixed fees, interest income, and other expenses are then subtracted from the net trading income to determine the net gain on which the performance fee is based. In the event that a loss due to trading occurs in a particular year, the fixed fees are charged to the client plan, but no performance fee can be earned for that year.

The value of an Account and its daily trading profit (or loss) are determined each day by totaling the results of all realized futures, options, and foreign currency forward trades (after commissions), plus the value of all open positions (determined as described above). You represent that Mount Lucas, the plan trustee, and the broker each generate information necessary to calculate the daily trading profits. For the larger Accounts, the plan trustee provides and maintains the official record of daily trading profits upon which the performance fee is based. Mount Lucas collects daily transaction records for each Account and, where required, provides a consolidated record of the transactions and their prices to the plan trustee. Mount Lucas also verifies this record with the broker. Also, at the end of each day, the plan trustee obtains settlement prices for open positions from independent third-party data services of its choice.⁽¹²⁾ The results of the daily trading for each Account are added together on a cumulative basis on December 31 of each year to determine whether trading profits have been earned that year.⁽¹³⁾ The plan trustee then confirms the calculations necessary to determine whether Mount Lucas has earned a performance fee, using this cumulative record of trading results to determine whether a new high level of Cumulative Profits has been achieved and applying the Index Profit figure, if applicable.

You represent that a plan's decision whether to retain Mount Lucas and to pay a performance-based fee is, in all cases, made by a plan fiduciary who is independent of Mount Lucas. You further represent that the present and anticipated future client plans of Mount Lucas generally operate through investment committees comprised of senior financial officers of the corporate plan sponsors. These investment committees take an active role in determining the investment of plan assets.

You further represent that an independent plan fiduciary may include in the investment management agreement a provision that requires Mount Lucas to notify the fiduciary and stop trading if losses in an Account reach a certain, pre-determined level. Furthermore, the level of portfolio margin⁽¹⁴⁾ in the Account (which appears in monthly statements that are provided by the independent broker to the plan) discloses the degree of risk to which an Account is currently exposed. An independent plan fiduciary is able therefore to monitor whether Mount Lucas or a CTA has altered the degree of risk to which an Account is exposed by reviewing the monthly statements for changes in the level of margin. Finally, you represent that Mount Lucas has in place procedures to prevent Mount Lucas or the CTAs from taking a "straddle position"⁽¹⁵⁾ with respect to two or more clients for the purpose of ensuring themselves a performance fee.

You represent that either party to a performance-fee arrangement may terminate the arrangement upon thirty to forty-five days' notice, or such shorter period as the parties may agree upon. In the event that either Mount Lucas or a plan terminates the arrangement on other than an annual valuation date, a determination of whether a performance fee has been earned will be made through the effective date of termination.

You request an advisory opinion that client plan's payment of a performance-based fee to Mount Lucas under the conditions and circumstances described above will not constitute a violation of section 406(b) of ERISA.

Section 406(a)(1)(C) and (D) of ERISA provides that a fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect furnishing of goods, services, or facilities between the plan and a party in interest or a 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 plan assets in his own interest or for his own account. Section 406(b)(2) of ERISA provides that a fiduciary with respect to a plan shall not in his 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 and beneficiaries.

Section 3(14) of ERISA defines the term "party in interest" to include a fiduciary and a person providing services to a plan.

Section 408(b)(2) of ERISA exempts from the prohibitions of section 406(a) any contract or reasonable arrangement with a party in interest, including a fiduciary, for office space, or legal, accounting or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor. Regulations issued by the Department of Labor (the Department) clarify the terms "necessary service" (29 CFR § 2550.408b-2(b)), "reasonable contract or arrangement" (29 CFR § 2550.408b-2(c)) and "reasonable compensation" (29 CFR §§ 2550.408b-2(d) and 2550.408c-2) as used in section 408(b)(2). In this regard, you have not requested an opinion that the proposed provision of services by Mount Lucas complies with the requirements of section 408(b)(2) of ERISA. As a general matter, whether the requirements of that section are met in each case involves questions which are inherently factual in nature. Pursuant to section 5.01 of ERISA Procedure 76-1, the Department ordinarily does not issue opinions on such matters.

With respect to the prohibitions in section 406(b), the regulation under section 408(b)(2) of ERISA (29 CFR §2550.408b-2(a)) states that section 408(b)(2) of ERISA does not contain an exemption for an act described in section 406(b) even if such act occurs in connection with a provision of services that is exempt under section 408(b)(2).

As explained in regulation 29 CFR § 2550.408b-2(e), the prohibitions of section 406(b) are imposed upon fiduciaries to deter them from exercising the authority, control, or responsibility that makes them fiduciaries when they have interests that may conflict with the interests of the plans for which they act. Thus, a fiduciary may not use the authority, control, or responsibility that makes him a fiduciary to cause a plan to pay an additional fee to such fiduciary, or to a person in which he has an interest that may affect the exercise of his best judgment as a fiduciary, to provide a service. However, regulation 29 CFR § 2550.408b-2(e)(2) provides that a fiduciary does not engage in an act described in section 406(b)(1) of ERISA if the fiduciary does not use any of the authority, control, or responsibility that makes him a fiduciary to cause a plan to pay additional fees for a service furnished by such fiduciary or to pay a fee for a service furnished by a person in which the fiduciary has an interest that may affect the exercise of his judgment as a fiduciary.

Based on the representations contained in your submission, it is the Department's view that the payment of a performance fee pursuant to the specific arrangement described above would not, in itself, constitute a violation of section 406(b)(1) of ERISA. It appears that the amount of compensation that Mount Lucas would earn depends solely on the changes in value of the contracts in the individual Account as compared to the performance of the Account at the end of prior calendar years, and, in some cases, to the Index, as determined by readily available market quotations or independent valuations. Therefore, in the situation you describe, it appears that Mount Lucas would not be exercising any of its fiduciary authority or control to cause a plan to pay an additional fee. Moreover, it does not appear that Mount Lucas would be acting on behalf of, or representing, a person whose interests are adverse to the plan merely because it enters into an agreement to provide investment management services pursuant to the arrangement described above. Accordingly, based on your representations, it is the Department's view that payment of a performance fee pursuant to such arrangement would not, in itself, constitute a violation of section 406(b)(2) of ERISA.

However, if, in operation, the provision of services by Mount Lucas pursuant to the described arrangement results in a divergence of interests between a plan and Mount Lucas, violations of sections 406(b)(1) and 406(b)(2) could occur. Accordingly, the Department is unable to rule that the described arrangement, in operation, would not violate those sections. For instance, results of trading activity in an Account (e.g., substantial losses in a short period of time) could cause the interests of the plan (to minimize losses) and Mount Lucas (to earn a performance fee) to diverge with respect to the acceptable degree of investment risk in the plan's Account, causing Mount Lucas to invest plan assets, in violation of section 406(b)(1) and 406(b)(2), in contracts with a higher degree of risk than is appropriate for or acceptable to the plan. This divergence of interests could occur at a level of loss that is short of the level of loss that would trigger an agreement to halt trading by Mount Lucas. Monthly disclosure of changes in the level of portfolio margin in an Account may not be sufficiently timely to inform the plan's independent fiduciary of a divergence of interests. In addition, the Department is not addressing issues relating to a fiduciary's allocation of investment opportunities among other Accounts over which he has discretion.(16)

ERISA's general standards of fiduciary conduct also would apply to the proposed arrangement. Section 404 requires a fiduciary, among other things, to discharge his duties respecting a plan solely in the interest of the plan's participants and beneficiaries and in a prudent fashion. Accordingly, the plan fiduciary must act prudently with respect to the decision to invest in futures contracts and related investment vehicles, and to enter into a performance-based compensation arrangement with an investment manager, as well as the negotiation of the specific formula under which compensation will be paid. It is the Department's view that in these circumstances a fiduciary could not act prudently in making decisions respecting such performance-based compensation arrangements unless the fiduciary had obtained all relevant information pertaining to the proposed arrangement with the investment manager and fully understood the compensation formula and the risks associated with this manner of compensation. A fiduciary making such decisions should also fully understand the risks involved in the particular types of investments being made by the manager. The fiduciary should understand, for example, that futures markets may be more volatile than securities markets, and that there is a potential for a performance-based compensation formula to induce the investment manager to make riskier investments than he would make in the absence of such a formula.

In addition, the plan fiduciary must be able to, and must in fact, periodically monitor the actions taken by the manager in the performance of its investment duties, with a frequency appropriate to the nature of the investment(s), and must be able to, and must in fact, take appropriate action when necessary. For example, if, during the course of a plan's relationship with Mount Lucas, a divergence of interests develops between the plan and Mount Lucas, the plan fiduciary must be able to detect the divergence and take steps to eliminate the conflict of interest in order to avoid a possible fiduciary breach and prohibited transaction. Accordingly, in considering whether to enter into an arrangement of the kind described in your letter, a fiduciary should take into account its ability to provide adequate oversight of the investment manager. Finally, we also note that, under section 405(a) of ERISA, any plan fiduciary (including an investment manager) will have co-fiduciary liability for any breach of fiduciary responsibility of another plan fiduciary: (1) if he knowingly participates in or conceals such breach; (2) if by his failure to comply with section 404(a)(1), he enables another fiduciary to commit such a breach; or (3) if he has knowledge of the breach of another fiduciary and he fails to make a reasonable effort to remedy the breach.

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. This opinion relates only to the specific issues raised by your request. For example, the Department is expressing no opinion with respect to the selection and retention of trading advisors, or the allocation of plan assets among such advisors.