On March 16, the Government Accountability Office issued a report on securities lending. This report, mandated by the Dodd-Frank Act, lays out recommendations to help employers and participants better understand the risks of "securities lending" in 401(k) plans. As we mentioned in our August 12, 2010 post, the Dodd-Frank legislation affects securities lending in a number of ways. The legislation requires:
- Changes to the statutory regime governing insolvencies of significant broker-dealers and other financial institutions.
- Limitations on the ability of Federal Deposit Insurance Corporation ("FDIC")-insured banks and their affiliates to sponsor, maintain and engage in transactions with cash collateral pools.
- Credit exposure limitations and additional capital requirements that may result in lower volumes of securities lending and repurchase agreement activity by affected banks and bank affiliates, both as principals and in indemnified agency securities lending programs.
- Enhanced limitations on transactions between affected banks and their affiliates, which may impact riskless principal or "conduit" lending and similar alternative lending programs.
- Changes to the federal securities laws that will result in additional disclosure in connection with securities lending.
The GAO report found, unsurprisingly, that a significant number of 401(k) retirement plans participate in securities lending, and 401(k) plan participants share any gains but fully bear any losses from cash collateral pool investments in the case of securities lending with cash collateral reinvestment. Further, 401(k) plan participants only receive a portion of the return when the reinvested cash collateral earns more than the amounts owed to others engaged in the transaction. Significantly, however, the GAO found that in the past few years, risky assets in the cash collateral pool, which lost value and were difficult to trade, caused material realized and unrealized losses to 401(k) plan participants. Also, the GAO concluded that some plan sponsors are often unaware that 401(k) plan investment options are engaged in securities lending with cash collateral reinvestment and that these arrangements can pose risks to plan participants.
The GAO's report concluded that current securities lending disclosures in the 401(k) plan context are often not appropriately transparent. GAO recommended that the SEC, Department of Labor, and others take action to assist plan sponsors in understanding, among other things, the potential gains and losses associated with the cash collateral pools, and to provide better guidance to plan sponsors and participants.
It should be noted that the SEC is required by Dodd-Frank to propose rules designed to increase the transparency of information available with respect to the lending or borrowing of securities. In addition, the Dodd-Frank Act amends the Exchange Act to strengthen the SEC's regulatory power over securities lending by make it unlawful to lend or borrow securities in contravention of the new SEC rules.
Once effective, these rules should assist fund independent directors in discharging their obligations to oversee their funds' securities lending programs.
The full text of the GAO report is available at: http://www.gao.gov/new.items/d11359t.pdf