August 7, 2006
The House and the Senate have passed the Pension Protection Act of 2006 ("Act"), and the President is expected to sign the Act into law. Most of the public scrutiny has been on the Act’s significant tightening of the pension plan funding rules. A less-noticed provision relating to the plan asset "significant" participation rule will allow many investment funds to take more pension plan assets without subjecting the funds to ERISA’s strictures. In addition, the Act has added a number of exemptions from ERISA’s prohibited transaction and fiduciary bonding rules. The Act raises some interpretive questions, but generally will be helpful to many investment funds and plan service providers. We expect to provide client updates as additional guidance is issued.
Present Exceptions. Under current law, unless an exception applies, equity investments in an entity by one or more plans subject to ERISA will cause the entity’s assets to become subject to ERISA’s various rules. In addition to the significant participation test (which is the prime focus of the Act’s plan asset changes), the key exceptions are for plan investments in certain publicly-offered securities, registered investment companies, operating companies, venture capital operating companies ("VCOCs"), and real estate operating companies ("REOCs").
Significant Participation Test. Under the significant participation test, the assets of the fund are plan assets if "benefit plan investors" own 25% or more of any class of equity of the fund. A benefit plan investor includes any employee benefit plan, any entity subject to section 4975 of the Internal Revenue Code (i.e., generally IRAs), and any entity whose underlying assets include plan assets by reason of a plan’s investment in the entity (e.g., another fund whose assets are themselves plan assets). For purposes of this test, employee benefit plans that are not subject to ERISA, such as governmental and foreign pension plans, nevertheless are treated as benefit plan investors and count against the 25% limit. In addition, in running the test, any equity interests held by a person (other than a benefit plan investor) who has discretionary authority or control with respect to the assets of the fund or any person who provides investment advice for a fee (direct or indirect) with respect to such assets, or any affiliate of such a person, are disregarded.
Consequences of Being Subject to ERISA. There are a number of adverse consequences if a fund’s assets are treated as plan assets, including:
If any investor in the fund is subject to ERISA, those who exercise discretion in managing the fund’s assets will be subject to ERISA’s fiduciary responsibility rules.
ERISA’s prohibited transaction rules will also apply to the fund if any investor is subject to ERISA. These rules can prohibit various activities that are common with funds not subject to ERISA.
If a fund makes "downstream" investments in another fund (e.g., because it is a fund of funds), the entire investment by the "upstream" fund counts as an investment by a benefit plan investor. This limits the universe of downstream investors that will accept investments by plan asset funds, because many downstream funds want to avoid exceeding the 25% limit.
Impact of the Legislation
The Act significantly liberalizes the significant participation test. The changes are effective with respect to "transactions occurring after the date of enactment of the Act." The two key changes are:
The term "benefit plan investor" is modified so that it only includes plans and other entities that are subject to ERISA or section 4975 of the Internal Revenue Code. In other words, investments by governmental and foreign plans, as well as by other plan asset funds that include plan assets (but are not subject to ERISA or the Code) are counted in the denominator of the 25% test but are not included in the numerator. Thus governmental and foreign plan assets can be used to help increase the amount of permissible investments by ERISA-covered investors.
An entity is considered to hold plan assets only to the extent of the percentage of equity interests held by benefit plan investors (as determined under the new definition). For example, if 40% of the equity interests in a fund are held by investors subject to ERISA and the Code, only 40% of the assets are subject to ERISA. Thus, if the fund invests in a downstream fund, only 40% of the fund’s investment will count in the numerator of the 25% test by the downstream fund (and the entire investment will count in the denominator). One complication this rule implicates is that changes in the composition of upstream funds may impact the ERISA status of downstream funds. As a result, downstream fund managers may want to leave a bit of "room" in calculating their 25% tests so that minor changes in the plan asset status of upstream investors will not trigger ERISA coverage of the downstream fund.
Opportunities for Investment Funds
Non-Plan Asset Funds (Other Than VCOCs or REOCs). Funds that are currently below the 25% threshold including most hedge funds should consider taking advantage of their now enhanced capacity to accept ERISA-regulated and non-ERISA-regulated plan assets without then becoming subject to ERISA.
Plan Asset Funds. Managers of investment funds that hold plan assets subject to ERISA should take the following steps:
Review their partnership agreements, subscription agreements, private placement memoranda, and other materials to determine whether any steps need to be taken if, as a result of the legislation, the fund’s assets are no longer subject to ERISA. For example, if the fund manager acknowledged that it was a fiduciary of the investing plans under the old rules, but the assets of the fund are no longer plan assets as a result of the Act, it may be necessary to modify these documents. In addition, if a fund were represented to be a plan asset fund but no longer is, contractual changes may be required.
Ask any "upstream" fund investors if their assets are no longer plan assets as a result of the Act. Even if the assets remain plan assets, only a proportional amount of those assets will now be plan assets, as described above. Put in place procedures for monitoring the upstream funds.
If the fund makes investments in downstream funds, communicate with the downstream fund managers regarding the plan asset status of the fund under the new rules.
VCOCs and REOCs. Managers of VCOCs and REOCs should consider whether it is still necessary to be a VCOC or a REOC. One key thing to keep in mind is that a VCOC or a REOC must qualify as such beginning with the first investment in the fund, so it is not possible to become a "springing" VCOC or REOC if the 25% test is later exceeded (e.g., as a result of new investors or the cashout of the interests of some non-benefit plan investors).
New Prohibited Transaction and Fiduciary Bonding Exemptions
In addition to the change to the significant participation test, the Act also provides a number of exemptions to the prohibited transaction rules under section 406(a) of ERISA. Some of these exemptions may be useful to investment funds that, even under the liberalized rules, hold ERISA plan assets. The new exemptions (all of which are subject to various conditions) are for:
Certain transactions involving the sale, exchange or leasing of property, extension of credit, or transfer of plan assets between a plan and a service provider to a plan (other than certain persons who have discretionary control over the assets involved in the transaction or render investment advice for a fee with respect to those assets).
Certain block trades involving at least 10,000 shares or securities with a market value of at least $200,000.
Certain cross-trades involving plans with assets of at least $100 million.
Certain foreign exchange transactions between a plan and a bank or a broker-dealer.
Certain transactions involving the sale of securities or other property using electronic communications networks.
Certain otherwise prohibited transactions incurred in connection with the acquisition, holding or disposition of any security or commodity (other than a transaction involving the acquisition or sale of employer securities or employer real property between a plan and the plan sponsor) that are corrected within 14 days of discovery (or when they should have been discovered). This exemption is not available if, at the time of the transaction, the "party in interest" that engaged in the transaction knew or should have known that the transaction was prohibited.
Fiduciaries and other service providers to ERISA-covered plans should consider the impact of these new exemptions, because transactions that were previously prohibited may now be subject to a statutory exemption. In addition, there are a number of conditions for the application of each exemption (including enhanced disclosure requirements in many cases), and these conditions should be carefully reviewed to determine what actions are required. Among other things, client service agreements should be reviewed to determine whether any changes are required to permit utilization of the new exemptions.
In addition, the Act provides an exemption from the ERISA fiduciary bonding requirement for entities that are registered as brokers or dealers under Section 15(b) of the Securities Exchange Act of 1934 and are subject to the fidelity bond requirements of a self-regulatory organization. Under this exemption, many broker-dealers that handle plan assets will no longer need to obtain separate ERISA fiduciary bonds.
Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or David West (213-229-7654, firstname.lastname@example.org), David I. Schiller (214-698-3205, email@example.com), or Michael J. Collins (202-887-3551, firstname.lastname@example.org).
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.
© 2006 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.