When a plan fiduciary contemplates investing plan assets in any type of investment, there must always be considerations of prudence, both in the process of making the decision and in the decision to invest. For some types of investment vehicles, though, there can be additional concerns, such as the possibility of prohibited transactions or conflicts of interest not inherent in other investment classes.
As a result of the recently soft markets, and the size of many public and private pension funds, there has been much interest and activity in investing in socalled “alternative” investments. This article will briefly explain the particular considerations that must be addressed when a plan fiduciary is contemplating an investment in two types of alternative investments: hedge funds and private or “venture capital” equity funds.
The Concept of Plan Assets
A key to the fiduciary rules of ERISA is whether, and the extent to which, someone is in control of, or dealing with, “plan assets.” For example, the definition of a fiduciary under ERISA includes those who have authority over plan assets. A fiduciary must invest plan assets prudently and diversify those assets, if appropriate, to avoid large losses. Transactions which are prohibited under ERISA relate to certain persons obtaining or using plan assets. Finally, the conflict of interest rules of ERISA Section 406(b) prohibit conflicts in dealing with plan assets.
Application of the Plan Asset Concept in Investment Transactions
In order to establish rules for determining what constitutes “plan assets” when a plan makes an investment, the Department of Labor published final plan asset regulations in 1986. (DOL Reg. section 2510.3–101). Essentially, the regulations distinguish between investments in “operating companies” and other investments. Operating companies generally are those enterprises that produce or sell a product or are performing a service, rather than being in the business of investing in other entities.
When a plan invests in an operating company by purchasing its stock, the plan asset is the stock, not the underlying assets of the company. This concept is critical to the company and the investing plan. If the investment was instead considered to be in the underlying assets of the company, then those assets would be “plan assets.” This would in turn mean that company’s board of directors and company officials would be fiduciaries of the investing plan. The business world would have considerable difficulty, to say the least, if company officials were considered fiduciaries of every investing plan. Among other things, the prohibited transaction rules would make such a state of affairs unworkable.
The Department of Labor believed, though, that investments in funds or other entities that were themselves investment vehicles, not operating companies, should be subject to the fiduciary rules. That is, where investment expertise was being relied upon by a plan in investing in a fund,¹ then the assets of the fund should be considered plan assets, thus implicating ERISA’s fiduciary rules. This general rule is referred to as the “look through” rule.
The regulations provide exceptions. Funds or investments that themselves are registered, such as mutual funds, are excepted. When a plan invests in a registered mutual fund, the plan asset is the unit owned by the plan and not the underlying assets of the fund. Accordingly, the managers of the mutual fund are not ERISA fiduciaries, but rather are regulated under the securities laws.
There are essentially two other exceptions, both of which relate to our main topic: alternative investments. The first exception is for a fund which has less than 25% of its value attributable to “plan investors.”² Such a fund will not be considered a “look through” investment; that is, the assets of the fund will not be considered plan assets. The DOL’s view is that where benefit plan investors in a fund are significant enough to exceed 25% of the equity interests in the fund, the managers should be held to the standards of a plan fiduciary. Conversely, where plan investment is below 25% it is considered not “significant” enough to impose ERISA’s fiduciary requirements on the fund’s managers. Hedge funds³ often rely upon this exception, and structure their acceptance of investors accordingly. One persistent problem in applying the 25% rule is that every sale, redemption or purchase of an interest in the fund requires a re-examination of continued compliance with the 25% rule.
The other exception in the regulation is for a “venture capital operating company,” often abbreviated as “VCOC.” (There is a similar exemption for real estate operating companies [“REOC”s].) These entities may also be referred to as private equity funds. There are numerous technical hurdles to overcome to be a VCOC. Without going into great detail, the fund must use at least 50% of its first investment(s) to acquire interests in one or more operating companies, obtain so-called “management rights” with respect to those investments representing at least 50% of its assets, and actually exercise those rights during each year in regard to at least one of the investments. The DOL’s reasoning for this exception is that where a fund has rights that are considerably greater than the rights an ordinary investor has, and exercises those rights, the fund is acting more like an operating company managing a business than as an investment company.
In both instances, for hedge funds and venture capital funds, the objective is generally the same for both the plan investors and the fund: to avoid the assets of the fund being considered plan assets. If the assets of a fund are plan assets, the managers of that particular fund will be considered ERISA fiduciaries. Furthermore, if the managers are not registered investment advisors, and thus cannot be designated as an “investment manager” under ERISA, the plan fiduciaries will be responsible for the prudence of each investment and other business activity of the fund.
For the fund managers, being an ERISA fiduciary requires a higher standard of care, and potential exposure to liability, than is normally associated with the management of hedge funds and venture capital funds. As a matter of business reality, all investors in such a fund, including those that are not ERISA plans, would have to be afforded the same standard of care by the fund managers as the ERISA investors.
Finally, the transactions within a hedge fund or venture capital fund between the general partner (or manager) and the fund could raise significant ERISA issues if the fund’s assets were considered plan assets. The types and bases of compensation of the general partner, lending between the general partner and the fund and other activities would likely run afoul of ERISA’s prohibited transaction rules, and other requirements for fiduciaries. Similarly, indemnification agreements, clauses limiting liability to “bad faith” behavior and the general business standard of care, all often found in fund agreements, would be superseded by ERISA. The potential for transactions prohibited under ERISA would also need to be considered in the manager’s dealings with parties both within and outside of the fund.
Satisfaction of the plan asset regulation so that the target investment will not be a “look through” entity generally obviates the need to be concerned about prohibited transactions or other fiduciary requirements in relation to the fund’s operations, over which the plan investor would have little control. The plan fiduciaries would still have the obligation to have chosen the investment prudently, including the assessment of the risks peculiar to these types of investments, but would not be responsible for the prudence of each investment decision made by the fund.
For all of these reasons, plan investors and fund managers will ordinarily want to satisfy one of the exceptions in the regulations to avoid “look through” treatment.
Considerations for Plan Investors
When a plan is contemplating investing other than through an investment manager or in publicly offered securities or mutual funds, the plan fiduciaries need to know whether the target investment vehicle is or is not a “look through” investment. If the investment is a “look through” investment, the Plan fiduciaries will need to review all aspects of the investment to understand the type of assets in which the particular fund is invested, what its investment(s) may be in the future, and how the managers will be compensated and how they will operate. Any potential prohibited transactions will also need to be considered. The plan may further require that the manager of the fund qualifies as an “investment manager” under ERISA.
For investments in hedge funds which satisfy the less than 25% standard and for investments in VCOCs, the rights and responsibilities of the parties will be defined by the contract the plan enters into with the fund. The potential for prohibited transactions will generally not be a concern. The other side of the coin, though, is that the sole responsibility for prudence in making the investment, and in monitoring its performance, will be with the plan fiduciaries. The fund’s managers will have contractual responsibilities but will not be ERISA fiduciaries, nor be subject to ERISA’s rules and standards.
Real World Situations
We have encountered a number of situations in which the plan asset rules became very relevant. As an example, in one case a pension trust chose a national investment firm to manage part of the plan’s assets. The document sent for review from the investment firm was a trust agreement. The agreement, among other things, stated that the trustees were not liable for their conduct, except for bad faith, were to be indemnified and did not have to be bonded. All of these terms violated ERISA. When pressed, the investment firm indicated the trust was not a look through investment by virtue of the less than 25% rule. When pressed further, it turned out that the trust currently exceeded the 25% threshold, which rendered the terms of the trust, among other things, improper. The situation was resolved by the investment firm offering to manage the chosen assets directly, and not through the trust. The firm was a registered investment advisor, so the solution was not a problem for the plan investor, but it was not the result initially contemplated by the manager.
In another instance, it was critical to the plan investor, in order to avoid potential prohibited transactions, that the investment fund be a VCOC in conformance with the DOL plan asset regulation. On examination of the fund and its investments, it was determined that the structure presented might not qualify as a VCOC. The fund and how it operated had to be restructured in order to satisfy the VCOC requirements before the plan would invest in the fund.
Plan fiduciaries need to know the type of investment they are considering and how it will be characterized under the plan asset regulation. Regardless of the investment’s technical characterization under ERISA, it is most important for the plan fiduciaries to have some basic understanding of the investment vehicle being proposed. It is difficult to be prudent if you do not have some understanding of the nature of the investment you are choosing and how it operates.
1. The term “fund” in this article is used broadly and could include a trust, limited liability partnership, limited liability company, partnership or other business entity.
2. The regulations define benefit plan investor broadly, to include not just plans covered under Title I of ERISA but also governmental plans, church plans and foreign pension plans, as well as individual retirement accounts (“IRAs”).
3. A hedge fund could be a direct investment fund or a fund of funds, characteristically trading in stocks, bonds, listed options, futures and OTC derivatives.