Interested in Offering CITs? Learn About the Regulations

David Kaleda

Collective investment trusts are not new. They have been around for decades and have, during the last 20 years, played an increasingly significant role as investment options in retirement plans. Their popularity likely will continue to grow, as CITs prove an excellent chassis for providing 401(k) plans exposure to alternative assets.

Yet many plan sponsors and other fiduciaries do not understand how the Employee Retirement Income Security Act applies to CITs or how CITs operate. Advisers can play a key role educating their clients about CITs, how they fit within a plan’s investment lineup and how they must be managed.

Structure

CITs must be maintained by a trustee—a nationally chartered bank, state-chartered bank or trust company. The trustee may hire affiliates or third parties to assist with managing CIT assets and day-to-day operations, such as the valuation of assets, pricing of units and trading, so long as the trustee ultimately maintains the CIT. Many CITs operate similarly to mutual funds and have become popular in participant-directed defined contribution retirement plans.

CITs are specifically exempt from registration under the Investment Company Act of 1940, Securities Act of 1933 and Securities Exchange Act of 1934. Therefore, they are not subject to securities laws. Neither the Securities and Exchange Commission nor the Financial Industry Regulatory Authority have any jurisdiction over CITs. Rather, they are subject to federal banking laws or state banking and trust company laws, depending on under what law the trust is formed.

Many CIT trustees are national association banks that are subject to federal banking laws and subject to regulation and enforcement by the Office of the Comptroller of the Currency. State banks and trust companies that function as CIT trustees must operate in accordance with applicable state banking and trust company laws and are subject to state regulators. Many state regulators look to federal law and OCC regulations as a basis for the application of state law. These federal and state laws, among other things: hold the trustees and other managers to a fiduciary standard; require the trustee to manage conflicts of interest; and assure that all CIT investors have a proportionate interest in all the trust’s assets.

Fiduciaries

CITs are also subject to the fiduciary duty and prohibited transaction provisions of ERISA. The trustee, any party responsible for managing CIT assets, and any party that provides investment advice in connection with CIT assets is a fiduciary for the purposes of ERISA. Therefore, trustees and other CIT fiduciaries must manage the CIT in accordance with the fiduciary duty provisions of ERISA Section 404 and the prohibited transaction provisions of ERISA Section 406. For the latter, the fiduciaries must comply with statutory and class prohibited-transaction exemptions, which mandate how the fiduciary must address certain conflicts of interest.

CIT fiduciaries can be sued under ERISA and held personally liable to ERISA-covered investors for a breach of fiduciary duty and violations of the prohibited-transaction provisions. The DOL has the authority to enforce the application of ERISA to CITs by means of litigation, conducted by its solicitor’s office, and investigations, conducted by its Employee Benefits Security Administration. Indeed, the DOL recently sued a CIT trustee for violating ERISA. Additionally, the DOL is actively conducting investigations of CIT trustees and other CIT fiduciaries.

Regulations

Therefore, while CITs are not subject to the securities laws, they are subject to substantial statutory and regulatory regimes that are designed to protect investors, albeit in a manner that may be different from the Investment Company Act or other securities laws. For example, neither banking law nor ERISA require that a CIT implement a liquidity management program like that required by SEC Regulation 22e-4 applicable to registered funds. However, to be sure, the CIT trustees adopt liquidity management programs that meet applicable banking law and ERISA’s fiduciary requirements. They similarly comply with banking law and ERISA when valuing the units of the CIT and its underlying assets.

Given the fact that CITs are both heavily regulated and exempt from securities laws, it is surprising that the DOL suggested in its proposed safe harbor regulation that the SEC requirements, by default, will meet ERISA’s requirements, but not give that same consideration to banking law or other means of compliance under ERISA that have been in existence for years. Hopefully, the DOL will change that in its final regulation.

Fiduciaries who intend to make alternative assets available in their 401(k) plans would do well to understand the regulation of CITs and, when issued, how to evaluate CITs under the DOL’s final safe harbor regulation. Plan advisers can play a key role in helping them do that.

David C. Kaleda is a partner in Eversheds Sutherland (U.S.) LLP.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.