If your plans have separately managed accounts, do you know if those managers are authorized to trade derivatives? Certain types of investment strategies, including many of those commonly used by employee benefit plans, may involve the use of swaps, futures, commodities, and other derivatives (we’ll refer to these types of instruments collectively as “derivatives”). These instruments can be valuable tools for your investment managers, but they can present certain legal risks best addressed in the agreement with the manager.

One key issue to confirm is the extent of the investment manager’s authority to expose assets of the plan in the event of a default by the plan or adverse developments in a derivatives trade. Often the trading documents for derivatives include a provision that the counterparty can collect against all assets of the plan, not only the assets of the account under the manager’s management. For some strategies, this may be necessary and appropriate. In other strategies, it may not be necessary or desirable.

Another issue is how margin and collateral requirements will be satisfied. Derivatives transactions generally require the plan to post specified amounts of money as margin or collateral. Does the investment manager allow the derivatives counterparty to use the amounts posted as margin or collateral (this is sometimes called “rehypothecation”)? Are there arrangements for excess amounts of margin or collateral to be returned to the plan at certain intervals?

As just these few questions likely reflect, derivative transactions can be very complex. Fortunately, plan fiduciaries do not need to understand all of these complexities themselves, but the investment management agreement presents an opportunity to confirm that the manager is addressing these complexities in the scope of the manager’s fiduciary duties to the plan.