Advisory Opinion 2003-02A
February 10, 2003
Lisa J. Bleier
Regulatory and Trust Affairs
American Bankers Association
1120 Connecticut Avenue, NW
Washington, DC 20036
Dear Ms. Bleier:
This is in response to your request, on behalf of the American Bankers Association, regarding the fiduciary responsibility provisions of the Employee Retirement Income Security Act of 1974, as amended (ERISA). Specifically, you have requested an opinion clarifying the application of sections 408(b)(2) and 408(b)(6) of ERISA to the provision of overdraft protection services, including any inherent extension of credit incident to such services, by banks, whether or not the bank or other financial institution or affiliate exercises investment discretion over plan assets.(1)
You represent that banks provide custodial or trust services to institutional clients, including employee benefit plans. A bank or its affiliate may also serve as investment manager for plans and other clients or as trustee and investment manager of collective funds in which plans invest. An essential part of bank custodial and trust services provided to clients, including employee benefit plans, is the orderly processing of the clients' securities and other financial market transactions, generally based on the anticipated receipt of funds to cover such transactions. In this regard, you indicate that banks have established settlement policies and procedures to maximize the efficiency of the securities trading in institutional accounts.
You note that plan investment performance would suffer significantly if a bank held up settlements to ensure that every sale scheduled to settle (thus generating funds necessary to effectuate subsequent transactions) had in fact settled or that anticipated funds had indeed been received. You represent that, although most transactions settle on time, settlement problems may arise due to errors, unexpected delays by a counterparty or its agent, settlement failures by a counterparty or its custodian, broker failures or inefficient markets. In the event of such a failure, banks will generally settle plan transactions without contemporaneous assurance that the necessary funds have been credited, in the correct currency, to the plans account. You represent that this overdraft protection is provided as part of a bank's and its sub-custodians' "standard operating systems and practices maintained routinely for all institutional customers." Overdraft protection is necessary to the custody service and is expected and demanded by plan and non-plan clients.
You explain that unlike a conventional loan between a plan and a bank, overdraft protection involves no agreement to lend a stated sum for a specified period of time. Events giving rise to an overdraft are generally inadvertent or outside the control of the bank or affiliate. A bank or an affiliate makes no specific discretionary decision to extend overdraft protection at the time of the settlement of a transaction and neither the plan nor its investment fiduciary makes a specific discretionary decision at that time to accept it. In fact, although the client is aware that overdraft protection is available, when needed, neither the client nor the bank is likely to be aware of the existence of any particular overdraft or its amount at the time that overdraft protection is actually provided. Banks recognize the extent to which overdrafts occur only in retrospect upon reconciliation of client accounts. Further, you represent that banks have procedures in place to discourage overdrafts and prevent clients, including plans, from using the overdraft protection as an intentional line of credit.
Your letter contains the following general information about overdraft protection procedures. Overdraft protection procedures are designed to ensure that overdraft protection is consistent with sound banking practice under published positions of both the Office of the Comptroller of the Currency and the Federal Reserve Board.(2) According to your letter, bank procedures, as well as agreements with plan clients, ensure that the terms of overdraft protection are at least as favorable to plans as the terms generally available in arm's length transactions between unrelated parties. After an overdraft is determined, a bank promptly notifies the appropriate investment manager or other plan fiduciary to determine the course of action that the fiduciary will take to correct the overdraft. Notice may be provided by telephone, facsimile, e-mail, through a bank's secure Web site or by some alternative method directed by the plan. Banks generally impose an overdraft charge and intend that such charge function as a disincentive for the investment fiduciary to intentionally prolong an overdraft. The overdraft charge is based on an objective measure that varies depending upon factors such as the custody location or currency involved. The overdraft charge may be defined by reference to an identified published rate. The overdraft charge, according to your letter, does not exceed "reasonable compensation."
You represent that banks disclose and obtain the consent of plan clients to the provision of overdraft protection. Bank disclosures describe the overdraft protection service and identify the objective basis for the overdraft charge. Consent may be affirmative if the plan client signs a trust, custody, or other agreement describing the services. Alternatively, consent may be deemed given following disclosure of the services.
As a trustee or custodian, a bank is a party in interest with respect to each plan. ERISA section 3(14) defines "party in interest" to include, among others, a fiduciary or person who provides services to a plan. Absent an exemption, a bank's provision of overdraft protection, as described herein, to plans would violate sections 406(a)(1)(C) and (D) of ERISA, which prohibit the provision of services by a party in interest to a plan and the transfer of assets from a plan to a party in interest. In addition, absent an exemption, any extension of credit between the bank and plan that may occur in connection with the overdraft protection would violate section 406(a)(1)(B) of ERISA. Moreover, if a bank uses any of the authority, control, or responsibility that makes the bank a fiduciary to cause a plan to pay to the bank an overdraft charge, the bank may violate sections 406(b)(1) and (2) of ERISA.
As discussed below, it is the view of the Department that the provision of overdraft protection services, including any inherent extensions of credit incident to such services, described in your letter would not constitute a prohibited transaction under section 406 to the extent that the bank providing such services complies with the requirements for relief under section 408(b)(2) or section 408(b)(6) of ERISA, as appropriate, and such provision of services is not otherwise part of an arrangement to secure credit unrelated to the settlement of securities or other financial market transactions.
Section 408(b)(2) provides a statutory exemption from the prohibitions of section 406(a) for contracting or making reasonable arrangements 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 clarify the terms "necessary service" (29 C.F.R. § 2550.408b-2(b)), "reasonable contract or arrangement" (29 C.F.R. §2550.408b-2(c)), and "reasonable compensation (29 C.F.R. §§ 2550.408b-2(d) and 2550.408c-2) as used in section 408(b)(2). Thus, overdraft protection services, in the context described in your letter, appear to be necessary to ensure the orderly processing of plan securities and other financial market transactions and, therefore, would appear to be a necessary service for purposes of section 408(b)(2) and § 2550.408b-2(b). Accordingly, such services would be covered by section 408(b)(2) to the extent such services are furnished under contracts or arrangements that are reasonable and no more than reasonable compensation is paid for such services within the meaning of § 2550.408b-2. As explained in § 2550.408b-2(a), section 408(b)(2) does not contain an exemption for an act described in ERISA section 406(b) (relating to conflicts of interest on the part of fiduciaries) even if such act occurs in connection with the provision of services that are exempt under section 408(b)(2).
Section 408(b)(6) of ERISA provides a statutory exemption from the prohibitions of section 406 for any ancillary services provided to a plan by a bank or similar financial institution supervised by the United States or a State, if such bank or financial institution is a fiduciary of such plan and certain conditions are satisfied. Section 2550.408b-6 further clarifies the application of section 408(b)(6). Such ancillary services include services that do not meet the requirements of ERISA section 408(b)(2) because the provision of such services involves an act described in section 406(b)(1) or (b)(2) of ERISA.
The Department has indicated that a service is "ancillary" if it aids or is auxiliary to a primary or principal service. The Department has concluded that the provision of "sweep services" by a trustee who is subject to direction from an independent investment manager for the investment of plan assets may constitute an "ancillary service" within the meaning of section 408(b)(6).(3) The Department also has indicated that the question of what constitutes an ancillary service within the meaning of section 408(b)(6) depends on the expectations of the parties as evidenced by the terms of the underlying service agreement and applicable Federal banking law.(4)
With regard to the expectations of the parties, you represent that plan fiduciaries are fully informed about, and approve, the terms governing the provision of overdraft protection services in settling securities and other financial market transactions for the plan, including associated charges.(5) Additionally, you represent that disclosure documents make clear that charges attendant to overdrafts are in addition to and separate from fees charged for other services, such as trustee or investment management services, provided by the bank or an affiliate. Given the foregoing and the fact that overdraft protection services appear to be necessary to ensure the orderly processing of plan securities transactions and other financial market transactions, as well as a banking practice recognized and permitted by Federal banking authorities, it is the view of the Department that the overdraft protection services described in your letter would constitute an ancillary service and, therefore, may be exempt from the prohibitions of section 406 if the conditions of section 408(b)(6) are satisfied. Whether any given bank satisfies the conditions of section 408(b)(6) is an inherently factual determination on which the Department generally will not rule.
Section 2550.408b-6(b) requires that ancillary services described in section 408(b)(6) must be provided at not more than reasonable compensation; under adequate internal safeguards which assure that the provision of such service is consistent with sound banking and financial practice, as determined by Federal or State supervisory authority; and only to the extent such service is subject to specific guidelines issued by the bank or similar financial institution which meet the requirements of 2550.408b-6(c). To date, no regulations have been issued to set specific requirements for such guidelines. However, the Department has stated that the condition contained in section 408(b)(6)(B) requiring "specific guidelines" is satisfied (in the absence of such regulations) if the ancillary services are provided in accordance with the specific guidelines issued by the bank or similar financial institution, and adherence to the guidelines would reasonably preclude such bank or institution from providing the services in an excessive or unreasonable manner and in a manner that would be inconsistent with the best interests of the participants and beneficiaries (See 47 FR 14806, April 6, 1982).
In order to reasonably preclude providing services in an excessive or unreasonable manner or in a manner that would be inconsistent with the best interests of the participants and beneficiaries, it is the view of the Department that guidelines relating to overdraft protection services, at a minimum, would be required to include measures designed to ensure timely notice to the appropriate plan fiduciary of any overdraft and the imposition of charges with respect thereto, to monitor and limit the duration and usage of overdraft services, and to limit the ability of a fiduciary to utilize overdraft protection services as a routine means by which securities and other financial market transactions are settled. For example, a pattern or practice of routine use of overdraft protection for settlement of securities or other financial market transactions would evidence the providing of ancillary services in an excessive and unreasonable manner and in a manner inconsistent with the interests of participants and beneficiaries in violation of section 408(b)(6).
ERISAs general standards of fiduciary conduct also apply to the overdraft protection services. Section 404 requires, among other things, a fiduciary to discharge his duties respecting a plan solely in the interest of the plan's participants and beneficiaries and in a prudent fashion and for the exclusive purpose of providing benefits and defraying reasonable expenses of administering the plan. Further, except as provided in section 408, fiduciaries also have an obligation under section 406 not to engage in self-dealing or to cause the plan to engage in certain transactions, including a direct or indirect furnishing of goods, services or facilities between the plan and a party in interest. In this regard, banks or institutions which act as investment managers to plans and provide through their affiliates or otherwise overdraft services would need to assure adherence with the conditions and guidelines specified in section 408(b)(6) of ERISA in the performance of those services.
As with the selection of any service provider, a plan fiduciary must engage in an objective process designed to elicit information necessary to assess the qualifications of the provider, the quality of the services offered, and the reasonableness of the fees charged in light of the services provided, including overdraft protection services. As with any compensation arrangement, plan fiduciaries should consider the circumstances under which services will be rendered and the charges for such services, the basis for such charges and the ability of the fiduciary to limit such charges.
This letter constitutes an advisory opinion under ERISA Procedure 76-1. Accordingly, it is subject to the provisions of the procedure, including section 10 thereof relating to the effect of advisory opinions.
Chief, Division of Fiduciary Interpretations
Office of Regulations and Interpretations
Under Reorganization Plan No. 4 of 1978, 43 FR 47713 (Oct. 17, 1978), the authority of the Secretary of the Treasury to issue rulings under section 4975 of the Internal Revenue Code (Code) has been transferred, with certain exceptions not here relevant, to the Secretary of Labor. Therefore, the references in this letter to specific sections of ERISA also refer to the corresponding sections of the Code.
You represent that the Office of the Comptroller of the Currency recognizes that overdrafts in fiduciary accounts are permissible if they are temporary in nature, made only for proper purposes and appropriately accounted for in the records of the bank. The Federal Reserve Board takes a similar position, permitting overdrafts that are temporary, corrected as soon as possible, kept to a minimum and adequately secured. Both agencies permit the imposition of a fee with respect to the overdraft if the policy is permitted under local law. See e.g., Fed. Res. Interp. Ltr. No. 5-942.22, (March 16, 1993), available at 1993 WL 764576 (F.R.B.).
See Advisory Opinion No. 2001-10A, December 14, 2001.
See DOL information letter to Robert Plotkin, August 1, 1986.
What constitutes an approval by an appropriate plan fiduciary will depend on the facts and circumstances of each case. See Advisory Opinions Nos. 97-16A, May 22, 1997 and 2001-01A, January 18, 2001.