It locks up and is not supposed to slip, hence the phrase "lock up". If it is slipping when locked up, the tranny will be contaminated with TC debris. This debris is what clogs fluid passages and leads to complete tranny failure. I had a 97 that suffered TC failure after a long trip with a toy hauler after changing the fuel plate. I was able to salvage the tranny by replacing the valve body and TC with a Goerend unit. I also replaced the 1-2 shift lever and front clutch pack at that time. I flushed the complete tranny and cooler and didn't have any other issues in the next 50K miles. It was very tight when locked up.
In regards to your question whether it is in fluid or not, I would have to say it is in fluid. The entire tranny and torque converter works off of hydraulic principles and tranny fluid comes in contact with everything inside.