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Senate Committee Recommends Reporting 401(k) Securities Lending Information to the SEC

By Jim Hamilton

A Senate Committee has recommended that companies in the business of securities lending should be required to report information on such practices to the SEC and bank regulators. Currently, while securities lending is a common practice in 401(k) plans, there is no comprehensive, public data available about securities lending, including securities lending within the qualified retirement plan market. A report prepared by the Senate Special Committee on Aging said that the disclosure to the SEC should include information on the cash collateral reinvestment portion of such companies? securities lending programs. Sponsors of qualified retirement plans that engage in securities lending also should be required to report basic information on securities lending within their plans to the Department of Labor.

To satisfy their responsibilities under ERISA, said the Committee report, plan sponsors should provide participants with sufficient information for them to make informed decisions about the investment options within their defined contribution plans. Although securities lending is a complicated topic, participants should be provided with easy to understand information and tools about securities lending and cash collateral reinvestment and the benefits and risks associated with the practice, including the potential for withdrawal restrictions

Securities lending is the practice of lending plan assets to third parties in exchange for collateral that a fund reinvests. The collateral for the loan can be either cash or other securities, such as bonds or stocks. However, in the U.S., cash is the primary form of collateral taken in securities lending. Many defined contribution and defined benefit plans participate in securities lending programs within their plans to generate additional revenue to cover fees or increase earnings.

In the case of securities lending with cash collateral within 401(k) plans, participants bear the ultimate risk of loss from the cash collateral pool investments. Securities lending agents generally do not reimburse plan participants for losses that the cash collateral reinvestment pool may suffer. However, in the event that there are gains from the investments of the cash collateral pool, participants generally share the gain with securities lending service providers, including broker-dealers and securities lending agents.

Senator Herb Kohl (D-WI), the Committee Chair, said that securities lending is a complex financial transaction that goes on every day, often without employers and employees even knowing it is going on within their plans. And even if they are aware, many do not understand the added risk. Ultimately, said the Senator, that risk lies with 401(k) participants because banks share the cash collateral profits but not the losses.

The SEC and FINRA are working on proposals for additional disclosure on securities lending. The Dodd-Frank Act calls for the SEC to promulgate rules no later than July 21, 2012, that are designed to increase the transparency of information available to brokers, dealers, and investors with respect to the loan or borrowing of securities. FINRA is also looking at promulgating rules that will ensure that broker-dealers allow customers to fully understand all the risks involved and that will focus on disclosing things from potential conflicts to restrictions firms may have on liquidating securities. FINRA has also asked for input on how to create an ADV-like form for broker-dealers, which is the key disclosure document used by investment advisers that requires detailed disclosures of services, conflicts, and fees.

According to a GAO report submitted to the Committee, it is unclear whether the improved disclosures being contemplated will provide information about the gains and losses from securities lending to investors and other stakeholders. Currently, banking regulators do not require banks to report gains or losses from their securities lending programs. Although FASB requires banks to make publicly available this information in their financial statements, the information is not reported to any federal regulator and is also not broken out by type of plan.

The Committee recommended that participants be given information about securities lending within their defined contribution retirement plan investment options. The Committee also recommended that companies arm themselves with knowledge of whether the investment options in their defined contribution retirement plans engaged in securities lending. If the answer is yes, for each investment option engaged in securities lending the company should determine the percentage of underlying assets that are being lent out and whether, in exchange for the loan, the plan?s service provider receive cash collateral or collateral in another form.

If it is cash collateral, what is the cash reinvested in and what are the returns (gains and losses) on such investments. The companies should also determine how the gains and losses are divided between the plan participants and the service providers and any fees received by the plan service provider, the broker, the cash collateral pool manager and the securities lending agent.

Full post as published by Jim Hamilton's World of Securities Regulation on March 17, 2011 (boomark / email).