Advisory Opinion 2002-05A

Dear Ms. Nussdorf:

This is in response to your request for an advisory opinion concerning Prohibited Transaction Exemption 77-4 (42 FR 18732, April 8, 1977) (PTE 77-4). Specifically, you request an opinion as to whether the prohibition on sales commission payments in PTE 77-4 would apply to commissions paid by a plan to an independent broker who executes the plan’s purchase or sale of shares of open-end investment companies registered under the Investment Company Act of 1940 through a securities exchange.

As you know, PTE 77-4 provides an exemption from the restrictions of section 406 of the Employee Retirement Income Security Act (the Act), as amended, and the taxes imposed by section 4975(a) and (b) of the Internal Revenue Code of 1986, as amended (the Code), by reason of section 4975(c)(1) of the Code, for the purchase or sale by an employee benefit plan of shares of an open-end investment company registered under the Investment Company Act of 1940, where the investment adviser for the investment company is also a fiduciary with respect to the plan (or an affiliate of such fiduciary) and is not an employer of employees covered by the plan, provided certain conditions are met.

Section II(a) of PTE 77-4 provides that the plan must not pay a sales commission in connection with such purchase or sale.

You represent that your inquiry concerns an investment vehicle known as an Exchange Traded Fund or ETF which is similar to a mutual fund. You have explained that an ETF is legally classified as a registered open-end investment company. Like other open-end investment companies, an ETF issues shares representing an undivided interest in a managed portfolio of securities. Additionally, ETF shares are offered continuously and may be purchased and redeemed directly through the ETF on a daily basis, at the net asset value (NAV) per share, with or without a fixed transaction fee.

You represent that direct purchases and redemptions occur, however, only in large blocks (generally called creation units) and generally are effected through an in-kind tender of a specified basket of securities, and not cash. You note that this tends to reduce portfolio turnover and attendant transactional expenses by minimizing the liquidations and acquisitions of portfolio securities required with respect to purchases and redemptions in ETF shares.

You state that individual ETF shares trade on the exchanges at market prices, which may differ from NAV. Trades of ETF shares in the secondary market incur brokerage commissions, like common stocks.

You have requested an advisory opinion confirming that the sales commissions precluded under section II(a) of PTE 77-4 do not include commissions paid to brokers provided that: (1) the sale of shares of open-end investment companies registered under the Investment Company Act of 1940 are executed through a securities exchange; and (2) the brokers are unrelated to the investment company’s principal underwriter or investment adviser (or their affiliates). You note that where the broker is not affiliated with the investment adviser for the fund and the fund’s principal underwriter, neither the adviser, the principal underwriter, nor any of their affiliates, derives any additional benefit from initiating a transaction which causes the broker to receive a commission.

ETFs did not exist in 1977 at the time PTE 77-4 was granted by the Department of Labor (the Department). At that time open-end investment company shares were purchased from the fund itself (or through a broker affiliated with the fund). The prohibition in PTE 77-4 on the payment of sales commissions by a plan was intended to avoid potential abuses that could arise if a mutual fund, its investment adviser or an affiliate thereof were to receive a commission or load in connection with the transaction. The Department explained in the preamble to the proposed class exemption relating to PTE 77-4 that the requirement that the plan not pay commissions would apply ...whether the transaction is between the plan and the mutual fund directly or is executed by the mutual fund’s principal underwriter or transfer agent as an intermediary. (See 41 FR 50516, November 16, 1976). Each of these types of transactions would involve payment of a commission to someone associated with the mutual fund.

The Department’s views regarding fees paid to parties with respect to transactions described in PTE 77-4 were also discussed in Advisory Opinion 93-13A, in which a company, serving as investment manager or trustee to employee benefit plans, proposed to invest the plans’ assets in affiliated mutual funds. The Department stated that conditions (d), (e) and (f) of PTE 77-4, relating to required disclosures and approval by an independent fiduciary, would not apply to fees paid to parties unrelated to the mutual funds’ adviser, or any affiliate, under the arrangement described in the advisory opinion.

As noted above, ETFs are a more recent development in the securities market and their trading procedures differ from those of traditional open-end investment companies. In this regard, creation units are traded directly with the fund in like-kind exchanges while individual shares are traded between investors on securities exchanges and result in brokerage commissions being paid to brokers who may or may not be related to the fund, investment adviser or any affiliates thereof.

Based on the above facts and representations, the Department is of the view that the term sales commission as used in section II(a) of PTE 77-4 does not include brokerage commissions paid to a broker in connection with purchases or sales of shares of registered open-end investment companies on an exchange if the broker is unaffiliated with the fund, its principal underwriter, investment adviser or any affiliate thereof.⁽¹⁾

The Department cautions, however, that where a plan fiduciary, who is an investment adviser to a fund, causes the plan to pay commissions to a broker-dealer who is an affiliate of such adviser or of the fund, such commission payments would be separate prohibited transactions under section 406(b) of the Act for which no relief is available under PTE 77-4. Section 406(b) prohibits a plan fiduciary from dealing with the assets of the plan in his own interest or for his own account, acting in his individual or in any other capacity in any transaction involving the plan on behalf of a party (or representing a party) whose interests are adverse to the interests of the plan or the interests of its participants and beneficiaries, or receiving any consideration for his own personal account from any party dealing with such plan in connection with a transaction involving the assets of the plan.

This letter constitutes an advisory opinion under ERISA Procedure 76-1 and is issued subject to the provisions of that procedure, including section 10, relating to the effect of advisory opinions. This opinion relates only to the specific issue addressed herein.