The Markets November 16, 2015

Wider U.S. Retirement Investing in China on the Horizon?

Volatility and geopolitical challenges aside, experts at one ERISA-focused law firm are hearing more frequent inquiries from qualified U.S. retirement plans about investing in domestic Chinese markets.
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George Michael Gerstein is an associate in the Fiduciary Responsibility group at Groom Law Group, where he advises financial institutions and plan sponsors about a broad range of issues related to Title I of the Employee Retirement Income Security Act (ERISA).

This section is concerned with some of the key aspects of fiduciary responsibility and prohibited transaction issues under ERISA, Gerstein explains, especially in connection with plan investments and related products. While much of the industry’s regulatory focus in recent years has been paid to a familiar list of issues—notably the definition and scope of the fiduciary relationship under ERISA, along with the increasing prevalence of state-run retirement programs for private sector workers—Gerstein tells PLANADVISER a new line of client inquiry is emerging: How can qualified retirement plans access potential growth in China?

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Gerstein says the conversation is currently unfolding around a pilot program called the “Shanghai-Hong Kong Stock Connect,” which he explains as an effort to link the stock markets in Shanghai and Hong Kong and bring greater accessibility, accountability and transparency to those markets for global investors. Under the program, investors in Hong Kong and Mainland China can trade and settle shares listed on the other market through exchanges and clearing houses in their home market.

It sounds obscure, but Gerstein has received an increasing number of client calls asking about what this could potentially mean for retirement plans in the U.S., “and whether it would work under ERISA.”

“I have the sense that asset managers are intrigued but are still in the exploration phase” regarding deeper expansion into China and the Shanghai markets via the Stock Connect, Gerstein says. “As for exposure, apparently some of the major indices will start including China A shares over the next couple of years … with many passive vehicles tracking indices.” Gerstein says the signs all show the asset managers that service U.S. retirement plans “consider this very much to be in play.”

NEXT: Why invest in China and Shanghai? 

Probably the most important detail for U.S. retirement plan investors regarding the Shanghai-Hong Kong Stock Connect is that certain international investors are able to use the platform to purchase eligible Shanghai-listed shares through their local broker. It's an inviting prospect in the search for return, given that the Shanghai market is often cited as the fifth-largest by market capitalization.

As Gerstein explains it, “the Shanghai-Hong Kong Stock Connect links the Stock Exchange of Hong Kong and the Shanghai Stock Exchange so that U.S. investors, for example, can trade China A shares directly. It launched last year and is significant. Prior to the Stock Connect, a U.S. investor had to have a special license or simply trade in A shares through derivatives. Now, it becomes easier to trade in domestic shares of the world's second largest economy.”

Stock purchased through the exchange is “self-contained and is designed to avoid hot money chasing the Chinese market,” he adds. “There are quotas and the restrictions that apply to foreign investors remain in place. The U.S. investor would access the Mainland market via Hong Kong. In other words, the U.S. investor would not have an account to hold the A shares with the Shanghai Stock Exchange. Instead, the investor's account would be in Hong Kong.” Other important details: the relevant A shares are denominated in the renminbi currency, and “we are dealing with equity only at this point.”

“I think the Stock Connect has been considered a success so far,” Gerstein says. “It's been stable and there's definitely been demand. Capacity will likely increase over the coming years, as well as the availability of different products, though it is tough to say with any certainty. Capacity will need to increase once A shares are included in some of the major indices.”

NEXT: What U.S. investors should consider

Gerstein says there is clearly growing interest among U.S. investors in gaining access to domestic Chinese stock markets.

“I think that most of them are still in the exploration phase, though,” he says. “Asset managers are still trying to understand the model and have raised some concerns. Fortunately, though, the Stock Connect has shown a willingness to address investor concerns.”

He shares the following technical example: “At first an investor would need to ensure that each of its executing brokers had sufficient securities in the investor's account to consummate the transaction prior to execution. This would need to be done on T-1. The investor would have several hours prior to execution when its assets were not held with its custodian. This worried people and so now there is an ability to leave the securities with the custodian until settlement.”

Still, there are issues that need to be worked out before U.S. investors really start rushing in, such as a clearer understanding of who holds custody of the A shares. “There also needs to be clear records of ownership,” Gerstein adds. “Again, I would imagine these issues will be addressed in one way or another.

“ERISA fiduciaries have asked whether trading over the Stock Connects works under ERISA,” Gerstein notes. “Certainly, there are the prudence considerations. Then, we need to remember that ERISA only allows plan assets to be placed outside the reach of the U.S. courts under very limited circumstances. Congress was worried about runaway assets. So, the key is to apply the ‘indicia of ownership’ rules to A shares. As the Stock Connect continues to fill in the blanks, this analysis hopefully becomes easier and provides a level of comfort to fiduciaries.”

Compliance November 16, 2015

State Street’s Handling of GM Stock for 401(k) Gets Court Blessing

After much back and forth, an appellate court has finally dismissed a lawsuit against State Street Bank and Trust Company over its handling of the employee stock ownership portion of General Motors (GM) 401(k) plan.
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Recognizing that it cannot rely on a presumption of prudence following the Supreme Court’s decision in Fifth Third Bank v. Dudenhoeffer, the 6th U.S. Circuit Court of Appeals said it evaluated State Street’s actions according to a prudent-process standard. The court interpreted the Dudenhoeffer decision to mean, and it held, that a plaintiff claiming that an employee stock ownership plan’s (ESOP’s) investment in a publicly traded security was imprudent must show special circumstances to survive a motion to dismiss. 

Using the rule of Modern Portfolio Theory (MPT), the court found that plaintiffs Raymond M. Pfeil and Michael Kammer failed to show a special circumstance such that State Street should not have relied on market pricing. The plaintiffs argued that there were four dates at which it would have been prudent for State Street to divest the plan from GM company stock.

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However, the court found that the plaintiffs did not offer legal reason why the four events suffice to trigger a particular reevaluation process, but instead rely on the observation that, after the four events, GM’s stock decreased in value. “We must evaluate the prudence or imprudence of State Street’s conduct as of ‘the time it occurred,’ not ‘post facto’,” the appellate court’s opinion says, noting that the plaintiffs’ reasoning invites a ‘post-hoc inquiry’ that MPT forbids.

NEXT: State Street’s prudent process

The appellate court agreed with a lower court that State Street had engaged in a prudent process for evaluating GM stock.

The opinion notes that State Street discussed GM stock scores of times during the class period. State Street’s managers repeatedly discussed at length whether to continue the investments in GM that are at issue in the case. State Street’s Independent Fiduciary Committee held more than forty meetings during the Class Period of less than nine months to discuss whether to retain GM stock. 

At those meetings, State Street employees discussed the performance of General Motors, both its stock and its business, and factors that may have affected that performance. Meetings often culminated in decisive votes, ultimately to divest the fund of GM stocks.

In addition, State Street was advised by outside legal and financial advisers which testified that State Street’s process for monitoring GM stock was prudent. And fiduciaries of other pension plans and non-pension-plan investment funds decided, like State Street, to hold GM Common Stock on each of the four “imprudent dates” chosen by the plaintiffs.

The 6th Circuit held that State Street’s actual processes demonstrated prudence, and the decision of other expert professionals both to invest and not to divest on or near the dates that State Street made its decisions demonstrates the reasonable nature of those decisions. 

NEXT: Case history

State Street was hired as the independent fiduciary for the ESOP component of the GM 401(k) plans in June 2006. The suit charged that State Street waited too long to sell off the GM stock in the company’s 401(k) plans; it divested in April 2009, but the plaintiffs claim that after July 2008, offering company stock was no longer prudent. The giant automaker filed for Chapter 11 bankruptcy June 1, 2009.

In 2010, a federal judge in Michigan threw out the case, saying that because participants could choose other investments in the plan, State Street could not be held liable. But, the 6th Circuit disagreed, sending the case back to the district court, saying it erred in relying on the Employee Retirement Income Security Act (ERISA) Section 404(c) safe harbor defense at this stage of the proceedings. 

In 2014, the district court again dismissed the case, finding that State Street engaged in a prudent decision-making process.

The 6th Circuit affirmed this decision. Its opinion in Pfeil v. State Street Bank and Trust is here.

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