 Investment Management Update
Pension Protection Act of 2006
August 2006
Impact on Investment Manager, Private Equity Funds and Hedge Funds
The Pension Protection Act of 2006 (PPA) contains the most significant changes to ERISA’s rules affecting the investment management community since the initial enactment of ERISA in 1974. These changes should simplify the applicable rules substantially. Both the House of Representatives and the Senate have passed the PPA, and the President has indicated that he intends to sign it later this month.
The provisions (except for the exemption from the bonding requirement) will be effective for transactions occurring after enactment. For these purposes, ERISA fiduciary responsibility is measured with respect to a person's role in an investment transaction (i.e., buy, sell or hold). Thus, beginning after the President signs the bill, the PPA will govern the question of whether an investment fund is subject to ERISA, or whether a manager or general partner is an ERISA fiduciary.
What are “Plan Assets” and how many Plan Assets can a pooled investment vehicle hold before becoming subject to ERISA?
If the assets of a pooled investment vehicle - such as a private equity fund or hedge fund - are considered “plan assets,” the pooled vehicle and its management may be subjected to the fiduciary and bonding requirements and prohibited transaction rules under ERISA. Under current Department of Labor regulations, a pooled investment vehicle is considered to be holding plan assets if 25 percent or more of its assets (disregarding certain investments by insiders) come from plan-type investors, including private employer retirement plans, IRAs, health savings accounts, governmental plans and foreign plans. If an entity were determined to be holding plan assets, then 100 percent of its assets (even the non-plan assets) would be considered “plan assets” in testing the status of any entity in which it invested. Practitioners refer to this as the “all or nothing” rule.
The PPA not only changes the manner of calculating the amount of a pooled investment vehicle’s assets that come from benefit plan investors, but also changes the “all-or-nothing” rule into a look-through rule.
First, while the 25 percent rule remains in effect, the categories of plan-type investors that are counted is narrowed. Under the PPA, all governmental plans (US, state and municipal) and all foreign plans (governmental and private employer-sponsored) are not considered assets of benefit plan investors for purposes of determining whether 25 percent or more of an entity’s assets comes from benefit plan investors.
This means that all government and foreign plans will be excluded from the numerator, although they continue to be counted in the denominator of the 25 percent test. After the PPA becomes law, while all assets in the pool (other than investments by certain insiders) are considered to be part of the denominator, if there is at least $1 of ERISA regulated money, only private-employer plans and IRAs are in the numerator. If 25 percent or more of the investment vehicle’s assets are plan assets, then the investment vehicle and managers are subject to ERISA if there is $1 of ERISA regulated money in the vehicle. So high net worth and non-ERISA IRA only funds will continue to be unaffected by ERISA.
Second, the PPA also changes the “all-or-nothing” rule. Under the PPA, an entity is considered to hold plan assets (after taking the 25 percent test into account) only in the proportion that the plan assets represent of the entire entity. Thus, if a “feeder entity” exceeds the 25 percent threshold, any fund in which it is invested now will consider only the actual proportion of plan assets in the feeder entity in determining whether the downstream fund is subject to ERISA. As an example, if $60 million of a $200 million fund of funds comes from benefit plan investors and the fund of funds invested in a $500 million underlying fund, then only $60 million will be counted as benefit plan money under the PPA. Previously, all $200 million would have been counted under the “all-or-nothing” rule. Under the PPA, the underlying fund now will not exceed the 25 percent threshold (assuming, of course, the underlying fund makes certain that the total plan assets it is deemed to manage are less than 25 percent).
The combination of the two rule changes will have a profound impact on the market. Investment funds now will be able to accept foreign and government pension plan money without limitation. A fund of funds that has less than 25 percent benefit plan investors, as redefined, will be able to continue to represent to underlying funds that it is not an ERISA investor. And if it does exceed the 25 percent threshold, the fund of funds will be able to represent to its underlying funds that it is a benefit plan investor only to the extent of the dollars taken into account in its own 25 percent test. In certain types of funds, including most hedge funds, this will be a dynamic and changing number that requires a fund that accepts fund of fund investments to consider imposing flow through limitations and/or to require that its fund of funds investors adhere to certain investment guidelines. There is no change in the requirement that these adjustments and this monitoring must be done in real time, not just at the time the investment is made.
Expansion of Service Provider Exemptions
If 25 percent or more of a pooled investment vehicle’s assets comes from benefit plan investors, the vehicle will be subject to the prohibited transaction rules of ERISA and, with respect to IRAs, the Internal Revenue Code. These prohibited transaction rules start with a presumption that any transaction involving plan assets is prohibited and then provide for a number of specific statutory exemptions which are relatively limited. The exemptions are augmented by a substantial number of complex prohibited transaction class exemptions issued by the Department of Labor, the goal of which is to permit routine transactions to continue on behalf of ERISA and tax-qualified plans.
The PPA will expand the statutory exemptions available to the investment community.
The most significant of the new exemptions are those relating to the provision of investment advice. In an attempt to encourage employers and 401(k) plan providers to expand their provision of investment advice to plan participants, PPA includes a specific exemption for the provision of investment advice to participants by providers and allows the provider to be compensated for providing the advice. Under an “eligible investment advice arrangement,” the provider’s fees may not vary depending on the investment chosen by the participant, or the advice must be provided through a qualifying computer model. The exemption is subject to specific notice requirements and must be subject to an annual audit for compliance with the specific provisions of the new rule.
Other new exemptions apply to routine transactions that in the past have led to inadvertent violations of ERISA, with no actual harm to plans. These exemptions include the following:
• An exemption for block trading at market prices, if no employer’s plan assets exceed 10% of the block trade. A block trade is defined as a trade of at least 10,000 shares or with a market value of $200,000 or more, where the proceeds will be allocated across two or more unrelated accounts managed by the fiduciary.
• An exemption for cross-trading (trading between two accounts managed by the same investment manager) if the trade involves no payment other than fair market value for the security, and another fiduciary of each plan has consented in advance to the investment manager’s participation in cross-trading (in a separate document, which also includes details concerning the investment manager’s policies and procedures). Quarterly reports detailing cross-trades are required, and the investment manager cannot base its fee schedule (or condition any other service) on the plan’s consent to cross-trading. Each plan involved in the cross trade must have assets of at least $100 million (the investment manager’s share of the total can be lower). A plan invested in a master trust maintained by a single employer (or a controlled group of employers) will satisfy this rule if the trust has assets of at least $100 million.
• The investment manager must maintain and follow written policies and procedures governing cross-trading, and must designate an individual responsible for periodic review of all cross-trades to ensure compliance with the procedures. An annual written report from such individual must be sent to all authorizing plan fiduciaries. The written report also must notify the authorizing plan fiduciary of the right to terminate the cross-trading authorization at any time.
• An exemption from ERISA’s fidelity bond requirement eliminates the bonding requirement entirely for any registered broker or dealer, if the broker or dealer is subject to the fidelity bond requirements of a self-regulatory organization (as defined in the Securities Exchange Act of 1934). This change is effective for plan years beginning after enactment.
• A fiduciary may use an electronic trading system without triggering the prohibited transaction rules if the system is subject to regulation, is designed to match purchases and sales at the best price available, and if the identity of the parties to the trades is irrelevant to the system. If the fiduciary has an ownership interest in the system, disclosure to the plan sponsor (and the approval of the sponsor) is required at least 30 days before the system can be used for transactions involving the plan’s assets.
• A new exemption has been added for security transactions between a plan and a party in interest (other than a fiduciary with investment authority over the transaction) if the plan pays adequate consideration for the security.
• A similar exemption is provided for foreign exchange transactions entered into by a bank or broker-dealer at an exchange rate within 3 percent of the inter-bank rate for comparable transactions, provided the bank or broker-dealer does not have investment discretion with respect to the transaction.
New Correction Period for Inadvertent Violations
Finally, the PPA recognizes that inadvertent violations of the prohibited transaction rules may still occur and therefore allows a 14-day correction period for a fiduciary to unwind a transaction without penalty if the fiduciary discovers an inadvertent prohibited transaction involving the acquisition or holding of a security or a commodity (other than employer securities), or if the fiduciary did not know or have reason to know that the transaction was prohibited when the transaction occurred.
The PPA is intended to expand the types of services, including routine investment advice, that could be offered to plan participants by their service providers without inadvertently tripping a prohibited transaction rule under ERISA and the Code. Based on these exemptions, the PPA should foster the flow of investment advice to plan participants without harm to plan assets.
Breaking News - August 14, 2006
On the heels of the SEC’s decision not to appeal the District of Columbia’s Court of Appeal’s decision in Goldstein v. Securities Exchange Commission, No. 04-1434, 2006 (D.C. Cir. June 23, 2006), the staff of the SEC on August 10, 2006 issued a “no action letter” providing some guidance for the post-Goldstein world.
The SEC’s letter is available at http://www.sec.gov/divisions/investment/noaction/aba081006.pdf
The court will issue its mandate on August 14, 2006 and the rules will be “vacated” at that time. The letter was necessary to fill gaps left by the decision. We will publish our analysis of the letter shortly.
Gregory J. Nowak, Julia D. Corelli and Susan Katz Hoffman |
