• ERISA and the Duty of Best Execution
  • November 29, 2005 | Authors: Michael A. Curto; Stacey G. Grundman
  • Law Firm: Patton Boggs LLP - Washington Office
  • Introduction

    Pension plan fiduciaries should not be overlooked in the crush of financial professionals trying to assess the impact of the changes in the structure of the nation's stock market, the rules governing those markets, and industry practices. Pension plans are major investors in the United States financial markets, accounting for approximately twelve trillion dollars in financial assets. The federal law governing pension plans, the Employee Retirement Income Security Act of 1974 (ERISA), was enacted to protect these pension assets from misuse so that plan participants receive the pensions they expect upon retirement. Toward this end, ERISA established a set of fiduciary requirements that govern the actions and decisions of those responsible for managing and operating pension plans. The U.S. Department of Labor (DOL), which has interpretive and enforcement authority over ERISA, has interpreted these fiduciary standards to impose a duty on plan fiduciaries to obtain the most favorable terms for investment transactions on behalf of a plan -- the duty of "best execution."2

    Determining whether a plan fiduciary has complied with ERISA's duty of best execution is a complex task. An evaluation of best execution should take into account a variety of execution attributes, including price, commission, speed of execution, market depth and other factors which are often difficult to evaluate. A plan fiduciary's best execution analysis may also need to incorporate external factors that impact the various execution attributes. New technologies and structural changes in the financial markets, for example, further complicate this already difficult task. In addition, new regulations issued by the Securities and Exchange Commission (SEC), requiring that trades be executed at the best quoted price available, create another challenge for plan fiduciaries attempting to conform to the duty of best execution. By elevating the importance of price over these other factors, the regulations make it difficult for plan fiduciaries to seek best execution in situations where other execution factors are significant.

    This paper describes ERISA's fiduciary standards and the duty of best execution in the ERISA context. It also discusses the challenges that a pension plan fiduciary faces in addressing his duty of best execution, particularly in light of some of the recent changes in the governing rules and structure of the investment industry.

    ERISA's Fiduciary Standards

    ERISA established a set of federal standards of conduct to govern fiduciaries of employee benefit plans. Under ERISA a fiduciary is defined based on a functional analysis. The functions individuals perform on behalf of a plan determine whether they are plan fiduciaries. Anyone who exercises discretionary authority or control with respect to the management of a plan or its assets, renders investment advice for a fee, or has discretionary authority or responsibility in the administration of the plan will be considered a fiduciary regardless of whether that person has been explicitly named a fiduciary. 3 Thus, any person who exercises investment discretion over plan assets is considered an ERISA fiduciary to that plan. Employers sponsoring plans and the officers or directors of those employers also are considered plan fiduciaries to the extent that their functions with regard to the plan include fiduciary activities.

    ERISA's fiduciary standards are designed to ensure that a fiduciary's action on behalf of a plan is made in the best interest of plan participants and beneficiaries.4 These standards require a fiduciary to discharge his duties in the interest of participants and beneficiaries for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan.5 This requirement is often referred to as the "exclusive purpose" rule.

    In addition, plan fiduciaries are required to act with the care, skill, prudence and diligence under the prevailing circumstances that a prudent man acting in a like capacity and familiar with such matters would use in similar circumstances.6 This requirement, referred to as the prudent man rule, is the keystone to the ERISA fiduciary responsibility provisions. It has been construed "as a procedural rule, requiring fiduciaries to thoroughly evaluate the various risks and benefits" of all investment-related decisions.7 The prudent man requirement may be satisfied by a fiduciary with respect to his investment duties if the fiduciary "(i) has given appropriate consideration to those facts and circumstances that, given the scope of such fiduciary's investment duties, the fiduciary knows, or should know, are relevant to the particular investment or investment course of action involved . . . and (ii) has acted accordingly."8

    Co-fiduciary Liability. In addition to its basic fiduciary responsibility provisions, ERISA imposes liability on plan fiduciaries for their co-fiduciaries' breaches of duty.9 An ERISA plan fiduciary is liable for the breach of fiduciary responsibility by another plan fiduciary if he knowingly participates in or conceals another fiduciary's breach, enables another fiduciary to commit a breach by failing to follow basic standards of conduct, or fails to make reasonable efforts under the circumstances to remedy a co-fiduciary's breach.10

    An ERISA fiduciary also is liable for the loss caused by the breach of fiduciary responsibility by another fiduciary of the plan if he enables the other fiduciary to commit a breach through his failure to comply with ERISA's prudence, exclusive purpose, and other requirements in carrying out his specific responsibilities. A fiduciary who knows that another fiduciary of the plan has committed a breach must take reasonable steps under the circumstances to remedy the breach.11

    Named Fiduciaries and Investment Managers. ERISA requires that a written plan instrument provide for one or more named fiduciaries who jointly or severally have authority to control and manage the operation and administration of the plan.12 A "named fiduciary" is a fiduciary who is named in the plan instrument or who, pursuant to a procedure specified in a plan, is identified as a fiduciary (A) by a person who is an employer or employee organization with respect to the plan or (B) by such an employer and such an employee organization acting jointly.13 Thus, a plan document may identify a named fiduciary by name, by office (such as the company president), or by identifying a procedure for selection by an employer or union (such as selection by the employer's board of directors).

    If the plan permits, a named fiduciary may appoint an investment manager, as defined by ERISA,14 to manage all or part of the plan's assets.15 The manager is required to act prudently both with respect to a decision to buy or sell securities as well as with respect to the decision concerning how the transaction will be executed. In such cases, the named fiduciary is not liable for the particular acts or omissions of the properly appointed investment manager but has a duty is to prudently select and monitor the actions of that investment manager. Thus, the named fiduciary's liability may be limited with respect to investment management functions as long as the named fiduciary chooses and retains the investment manager prudently.

    Prohibited Transactions. ERISA prohibits a fiduciary from causing a plan to enter into certain types of transactions (e.g., loans, sales, or the provision of services) with parties in interest. 16 A party in interest includes, among others, a person who is a fiduciary to a plan, the employer who maintains a plan, service providers to a plan, and affiliates of these persons.17 ERISA also bars a plan fiduciary from dealing with plan assets in his own interest or for his own account, or entering into a conflict of interest situation.18 These fiduciary responsibility provisions reinforce the concept that liability will result from the use of plan assets other than for the exclusive benefit of participants and beneficiaries of the plan.19

    ERISA's Fiduciary Duties and Best Execution

    DOL recognizes that the duty to obtain best execution is an element of a fiduciary's obligations under ERISA.20 The duty of best execution is fundamental to U.S. securities law and has its roots in the common law duty of loyalty, which requires brokers to maintain undivided allegiance to the interest of their clients and bars them from using their position for personal gain.21

    Best execution is often described as obtaining the best price under the circumstances. DOL, however, has cautioned that the quality and reliability of the execution must also be considered in determining whether the duty of best execution has been met.22 There are, however, no rules specifying how the quality or reliability of a trade should be measured. These factors are affected by, among other things, the account order size, trading characteristics of the security, speed of execution, clearing costs and the cost and difficulty of executing an order in a particular market.23 Some suggest that execution attributes such as "the timing of trades, the trading mechanism used, the commission charged, and even the trading strategy employed" should also be considered when seeking best execution.24

    Plan Fiduciaries Engaging in Soft Dollar and Directed Brokerage Arrangements. The duty of best execution is frequently examined with respect to soft dollar transactions and directed brokerage. A soft dollar arrangement generally refers to an arrangement where "a portion of the commissions generated by an investment manager through the purchase and sale of securities on behalf of [a plan] is used to purchase research and brokerage services that will be utilized by and for the investment manager rather than [the plan] generating the commissions."25 Generally, soft dollar arrangements would not satisfy ERISA's fiduciary requirements because the fiduciary investment manager uses plan assets (i.e., the commissions generated by the plan's securities trades) to secure goods and services for itself, even though the goods and services do not directly benefit the plan whose trades generate the commissions that pay for the services. However, where an investment manager has entered into a soft dollar arrangement, section 28(e) of the 1934 Securities Exchange Act relieves a person who exercises investment discretion from the applicability of the fiduciary provisions of ERISA if the person has determined in good faith that the commission was reasonable in relation to the services provided.26

    A plan fiduciary who appoints an investment manager retains an ongoing duty to monitor the investment manager to assure that the manager has secured best execution of the plan's brokerage transactions and to assure that the commissions paid on such transactions are reasonable in relation to the value of the brokerage and research services provided to the plan.27 The Assistant Secretary of Labor for the Employee Benefits Security Administration, the agency that administers and enforces the fiduciary provisions of ERISA, has reiterated this point on numerous occasions, noting that a "plan fiduciary should know and approve its investment manager's [soft dollar] arrangement. The fiduciary should determine whether research and services being purchased with the plan's brokerage are worth the higher trading costs and that the broker has provided the best execution of the trades." 28

    In contrast to soft dollar arrangements, which may be permissible despite their inherent conflict with ERISA's fiduciary requirements, directed brokerage arrangements must meet ERISA's fiduciary provisions because they do not fall within the scope of the section 28(e) safe harbor.29 Directed brokerage refers to arrangements whereby a plan sponsor requests its investment manager, subject to the investment manager's duty to obtain best execution for the plan, to direct trades to a particular broker who will provide services, pay obligations or make cash rebates to the plan. Such arrangements are outside of the section 28(e) safe harbor, which is only available to persons who are exercising investment discretion. Here, the plan sponsor who instructs an investment manager to direct trades to a particular broker-dealer is not exercising investment discretion.30 Thus, in order for directed brokerage arrangements to comply with ERISA's fiduciary duties, the commissions generated by a particular client and the goods and services received in return for those commissions must be used exclusively for the benefit of the plan that generates those commissions, unlike a soft dollar arrangement where the investment manager can consider the overall benefit to its managed accounts.

    With respect to directed brokerage, plan fiduciaries must meet all fiduciary obligations to a plan when they instruct the plan's appointed investment manager to use a particular broker.31 In so doing, the fiduciaries initially must determine that the broker-dealer is capable of providing best execution and evaluate whether the commissions are reasonable in light of the services provided. In addition, the plan fiduciaries must continue to monitor the broker's execution of transactions for the plan.32

    Broad Application of the Duty of Best Execution. While the duty of best execution is frequently raised in the context of soft dollar and directed brokerage arrangements, the duty is not technically limited to this context. Clearly, fiduciaries must evaluate the price of a trade, including the commission, and the value of the research and brokerage services received in exchange when they are determining whether they have secured best execution. However, the concept of best execution encompasses much more.

    Execution terms may be affected by a number of measures of market liquidity that have been examined in studies of exchange market liquidity. 33 One such study defines market liquidity as the ability of an investor to buy or sell shares whenever he chooses at the price other investors would pay or receive.34 The study explains that if a market does not provide sufficient liquidity, an investor offering to buy or sell shares may drive up the price to attract sellers or drive down the price to attract buyers -- shifting the terms of execution.35

    One common measure of liquidity described is the average effective spread which is based on the difference between the actual price of a trade and the midpoint between the best bid and best offer. Another measure of liquidity focuses on how quickly investors can execute their trades. The market with greater liquidity requires less time to match buyers and sellers to complete trades. The study also explains that execution capabilities are affected by market depth, which is determined by the size of the orders that can be filled at a given price -- the deeper the market, the more shares trade at a set price. One basis for measuring market depth would be the liquidity available for large institutional orders -- like those by pension funds.36

    The greater the liquidity an exchange can provide, the less impact a large order will have on a stock's price. The amount that a large order moves a stock price away from its fundamental value is referred to as depth volatility or transitory volatility. When the price of stock is affected by new information about a firm, sector, or the overall economy, the shift is referred to as informational volatility.37 All types of volatility may affect the terms of execution.

    Thus, an ERISA plan's investment manager must consider a complicated set of execution attributes to evaluate whether the duty of best execution is satisfied. In addition, the plan's named fiduciary (often the plan sponsor) must verify that the investment manager has included these attributes in his execution analysis.

    Changes Affecting Execution

    The broad range of execution attributes is further complicated by the fact that the standard for best execution has evolved over time. Many technology changes permit improved executions for customer orders and, thus, raise the standard for satisfying the duty of best execution. For example, before the creation of NASDAQ, a broker in an over-the-counter market satisfied her duty of best execution by contacting at least three market makers prior to executing a client's order.38 A plan fiduciary's duty of best execution is no longer so easily or definitively satisfied. Advances in technology have made markets faster, more efficient and more competitive.

    Changes to the structure of the U.S. exchange markets also affect the terms of execution. Planned mergers announced by the New York Stock Exchange (NYSE) and the NASDAQ Stock Market earlier this year will create significant changes to the structure of the exchange markets. The NYSE's plan to merge with all-electronic Archipelago Holdings, Inc. and NASDAQ's planned acquisition of an electronic trading platform owned by Instinet illustrate the effort by the exchanges to provide faster and more efficient trades and improve their competitive positions with respect to each other and the global marketplace. Success in these efforts will affect the terms of trade transactions executed on these or other exchanges. Plan fiduciaries may need to explore, understand, and research the impact of these structural changes in order to refine their investment procedures to satisfy their duty of best execution.

    Regulation NMS

    Recent action by the SEC raises another set of questions about best execution for ERISA fiduciaries to grapple with. Last April, the SEC approved new rules under Regulation NMS, changing the rules governing the U.S. securities market39 The key provision of the regulation is a "trade-through rule" that requires brokers to execute trades in the market showing the best price -- regardless of the other factors that may affect an investor's choice of market. The rule "is intended to take advantage of the existence of automatic trading systems that are readily and almost instantaneously accessible from around the country and the world."40 This "best price" approach, however, does not eliminate the significance of other execution factors that must be considered in evaluating best execution from an ERISA perspective. Although execution price is clearly an important consideration for fiduciaries, as noted above, DOL has cautioned that a plan fiduciary's responsibility to seek best execution requires consideration of the quality and reliability of execution as well.41

    The trade-through rule's signal that only the quoted price matters is difficult to reconcile with ERISA's fiduciary duties and particularly with respect to the duty of best execution. The two will not always coincide. Under the trade-through rule, the market posting the best quote will get order flow regardless of its speed or quality of execution or the fees that it charges -- factors that may impact the overall terms of execution.42 Moreover, the trade-through rule does not seem to acknowledge the significance large investors are likely to place on market depth. The limited number of shares (determined by the investors or traders submitting the limit orders) available at the best bid and best offer is significant for institutional investors, like pension plans, because the number of shares available or the price offered at the best price may be less than the number of shares the large investor wants to buy or sell. Any remaining shares will not be purchased or sold at the best price. Thus, large investors are likely to care not only about the best bid or best offer but also about market depth and the bids and offers submitted at other prices because some of a big sell or big buy order may be executed at prices other than the best price.43

    Another concern raised relates to the consequences of submitting an order to a smaller exchange offering the best price and having another investor's order arrive first. In such a scenario, an investor may be deprived of the opportunity to trade at the displayed price. The late-arriving investor's order may then be executed at a much worse price than would have been available on the larger exchange. It seems, therefore, that at times, investors may be able to reduce execution cost risk by directing their orders to a bigger exchange, even when it is not quoting the best price.44

    In addition, some have argued that since quotes change rapidly, an investor who sends an order to an exchange displaying the best quote may discover that another exchange offers a better quote after the order has been sent. Thus, there may be situations where it is difficult to reconcile the trade-through rule with the ERISA duty of best execution. ERISA plan fiduciaries would probably benefit from some assistance in reconciling these competing priorities.


    Almost 20 years ago, DOL pronounced that ERISA fiduciaries have a duty to obtain best execution for the plans they represent. At that time, DOL also made clear that plan sponsors retain this duty even where they have delegated investment management responsibilities to investment managers. DOL guidance pointed out that plan sponsors who have delegated investment authority have a fiduciary duty to monitor the performance of the investment manager and that this monitoring responsibility includes a duty to ensure that the investment manager has complied with ERISA's best execution duty and other fiduciary standards.

    The guidance, thus, indicates that the plan sponsor must not only monitor an investment manager's portfolio choices but also whether the investment manager is obtaining best execution as he creates or changes the composition of the plan's investment portfolio. As DOL noted, evaluating best execution requires an analysis that extends beyond the price obtained for a security -- the quality and reliability of the execution are also important factors in the best execution equation. Thus, these execution attributes must be considered by the investment manager and monitored by the plan sponsor. This is no easy task.

    There are a variety of complex conditions that impact the quality and the reliability of trade execution. Changes in technology and changes in the rules governing the investment industry further complicate the best execution analysis. Given the dearth of specific guidance for plan fiduciaries in this area, it would be wise for plan fiduciaries to carry out their responsibilities with respect to the monitoring of trade execution terms in a procedurally prudent manner by demonstrating that they have taken into account the various factors that affect the terms of execution. Finally, it will be interesting to observe how the enactment of Regulation NMS and the new trade-through rule affects ERISA's duty of best execution. Perhaps just as DOL took the opportunity to address the implications of the Securities Exchange Act section 28(e) safe harbor for ERISA twenty years ago, DOL will try to clarify the effect of the trade-through rule on the duty of best execution for plan fiduciaries.

    1 Mr. Curto is a partner at the Washington, D.C. law firm of Patton Boggs, LLP and manages the firm's employee benefits group. Ms. Grundman is an associate in the employee benefits group.

    2See Labor Dept. Statement on Policies Concerning Soft Dollar and Directed Commission Arrangements, ERISA Technical Release No. 86-1, 13 BPR 1007 (May 22, 1986).

    3 ERISA, Pub. L. No. 93-406, § 3(21)(A), 88 Stat. 829 (1974).

    4 Tech. Release 86-1.

    5 ERISA § 404(a)(1)(A). [6] ERISA § 404(a)(1)(B).

    7Donald J. Meyers, Directed Brokerage and Soft Dollars Under ERISA: New Concerns for Plan Fiduciaries, 424 Bus. Law 553, 555 (1987).

    8 29 C.F.R. § 2550.404a-1(b)(1) (2005).

    9 ERISA § 405(a).


    11 Id.

    12 ERISA § 402(a)(1).

    13 ERISA § 402(a)(2).

    14 See ERISA § 3(38).

    15 ERISA § 402(c)(3).

    16Specifically, ERISA § 406(a)(1) specifies five categories of transactions that a fiduciary shall not cause a plan to execute if he knows or should know that any such transaction, directly or indirectly, is effected with a party in interest. These prohibited transactions include: (A) any sale, exchange, or leasing of any property between a plan and a party in interest; (B) the lending of money or other extension of credit between a plan and a party in interest; (C) the furnishing of goods, services, or facilities between a plan and a party in interest; (D) any transfer to, or use by or for the benefit of, a party in interest of any assets of a plan; and (E) causing a plan to acquire and to retain employer securities or employer real property in violation of the restrictions on the acquisition and holding of such securities and real property.

    17 ERISA § 3(14).

    18 ERISA § 406(b)

    19 ERISA § 403(c)(1) states, in pertinent part, "the assets of a plan . . . shall be held for the exclusive purposes of providing benefits to participants in the plan and defraying reasonable expenses of administering the plan."

    20 Tech. Release 86-1.

    21Jonathan Macy & Maureen O'Hara, From Orders to Markets, 7/1/05 Regulation 62 at 1 (2005).

    23 Tech. Release 86-1, note 4.

    23 Payment for Order Flow, Exchange Act Release No. 33, 026, 58 Fed. Reg. 52934, 52937-38 (Oct. 13, 1993).

    24 Jonathan Macy & Maureen O'Hara, The Law and Economics of Best Execution, Journal of Financial Intermediation 6, 188, 189 (1997).

    25David M. Cohen, Selected ERISA Issues Affecting Broker-Dealers, 615 PLI/TAX 57, 68 (2004).

    26 Tech. Release 86-1.


    28 See, e.g., Keynote Address of Assistant Secretary Ann L. Combs to the Professional Liability Underwriting to the National Conference of the Society of Professional Administrators and Recordkeepers, May 13, 2004, http://www.dol.gov/ebsa/newsroom/sp051304.html (visited on Sept. 26, 2005); Remarks of Assistant Secretary Ann L. Combs to the Washington Briefing of the Financial Women's Association, March 29, 2004; http://www.umet-vets.dol.gov/ebsa/newsroom/sp032904.html (visited on Sept. 29, 2004); Remarks of Assistant Secretary Ann L. Combs to the Washington Forum of the U.S. Institute, Mar. 8, 2004; http://www.dol.gov/ebsa/newsroom/sp030804.html (visited on October 7, 2005).

    29Cohen, supra note 25 at 75.

    30 Id. at 74.

    31 Tech. Release 86-1.


    33See, e.g., Robert J. Shapiro, Costs for Investors of Trading on the NYSE and NASDAQ: A Floor-Based, Specialist Auction Market, versus and Open Access, Computer-Based Network (Pacific Research Institute, San Francisco, CA, Nov. 2004); Gregory Bresiger, Study Narrows Spread Between ECNs and Market Makers, Traders Magazine, Aug. 1, 2005.

    34 Shapiro at 7.

    35 Id.

    36 Id. at 11.

    37 Id. at 12.

    38 Newton v. Dean Witter Reynolds, 135 F.3d 266, 271 (3d Cir. 1998).

    39Regulation NMS, 70 Fed. Reg. 37496, June 29, 2005 (codified at 17 CFR pts. 200, 201, et al.).

    40 Craig Pirrong, The Thirty Years War, 7/1/05 Regulation 54 (July 1, 2005),WLNR 12659654 @ 2.

    41 Tech. Release 86-1, note 4.

    42 Pirrong, supra note 40 at 7.

    43 Id. at 4-5.

    44 Id.