Pension Protection Act of 2006 Adopts Key Changes to ERISA Plan Asset and Prohibited Transaction Rules

After its final approval by the U.S. Senate on August 3, 2006, the Pension Protection Act of 2006 ("PPA") was signed by the President and became law on August 17th. While the PPA adopts many significant changes to the rules governing the operation of benefit plans,¹ there are several key provisions of particular note for the financial services and private equity industries as well as others involved in the investment and management of pension plan assets. Taken together, these provisions should offer meaningful relief for fund managers, underwriters, issuers and plan fiduciaries from the often-complex web of restrictions imposed on the investment of pension plan assets by the Employee Retirement Income Security Act of 1974, as amended ("ERISA") and the related regulations promulgated by the U.S. Department of Labor ("DOL").

As a general rule, ERISA subjects investment managers and others possessing discretionary authority or control over the assets of pension plans to a range of fiduciary responsibility requirements, including strict standards of conduct and limitations on certain transactions involving "plan assets" (referred to as "prohibited transactions"). Prior to the passage of the PPA, ERISA did not define the term "plan assets." However, Section 2510.3-101 of the ERISA regulations (commonly referred to as the "Plan Assets Regulation"), adopted by the DOL in 1986, provided a multifaceted definition of the term, several key aspects of which are refined by the PPA.

The Plan Assets Regulation was intended to limit opportunities for investment managers and others handling plan assets to circumvent ERISA’s fiduciary responsibility and prohibited transaction rules by using an intermediate entity such as a limited partnership to indirectly provide services to investing plans.² To further this purpose, the Plan Assets Regulation treats a plan’s acquisition of an equity interest in another entity as plan assets and "looks through" that entity and deems its underlying assets to be plan assets as well unless an exception is available.³ We refer to this rule as the "look-through rule" here. One of the most commonly relied-upon exceptions to the look-through rule relates to the "significance" of equity participation in an entity by "benefit plan investors."⁴ We refer to this exception here as the "25% Test."

Under the current Plan Assets Regulation, "benefit plan investors" include not only pension plans, individual retirement accounts ("IRAs") and other benefit plans subject to ERISA or the prohibited transaction provisions of the Internal Revenue Code, but also plans that are not subject to ERISA such as those maintained by governmental entities and churches and those maintained outside the United States. Participation by benefit plan investors is deemed to be "significant" where such investors hold 25% or more of the value of any class of equity interests in the entity, excluding for purposes of this calculation, any equity interests held by a person (other than a benefit plan investor) who has discretionary authority or control over the entity’s assets or who provides investment advice for a fee with respect to the entity’s assets.

If an entity is not able to satisfy the 25% Test or another exception, the look-through rule will apply, and a number of potentially adverse consequences will arise: the entity’s managers and any others who exercise discretion over the investment of the entity’s assets will be subject to ERISA’s fiduciary responsibility requirements and the prohibited transaction rules imposed by both ERISA and the Internal Revenue Code of 1986, as amended ("Code"). The application of these rules can complicate or frustrate the entity’s investment objectives or management by limiting or prohibiting activities that the managers might otherwise undertake. Further, if such a "plan assets" entity makes its own investments in other entities (e.g., a fund of funds making downstream investments), those investments will be considered to have been made by a benefit plan investor. This may limit investment opportunities in downstream entities that are themselves attempting to avoid the Plan Assets Regulation by relying on the 25% Test.

The PPA makes four significant changes to ERISA and the Code which should ease the compliance burdens associated with the Plan Assets Regulation and the prohibited transaction rules.

1. Revised Definition of "Benefit Plan Investor"

For purposes of applying the 25% Test, Section 611(f) of the PPA revises the definition of the term "benefit plan investor" to include only plans and plan asset entities (i.e., entities that are themselves deemed to hold plan assets by virtue of investments in them by plans) that are subject to part 4 of Title I of ERISA or Code Section 4975. This change will exclude governmental, church, and foreign benefit plans from consideration as benefit plan investors: in other words, these plans will no longer count as benefit plan investors under the 25% Test.

The practical effect of the revised definition will be to increase the amount of permissible investments by the plans and plan asset entities that are still taken into consideration. Moreover, this change will assist entities that have had difficulty in satisfying the 25% Test in the past because of investments made by governmental and foreign plans. For example, under prior law, if a foreign pension plan acquired a 24% equity stake in a fund, less than 1% of the fund’s equity would be available to U.S. plans if the fund’s management hoped to satisfy the 25% Test. Under the law as modified by the PPA, the foreign plan’s 24% investment is not counted as a benefit plan investment, thereby providing a much greater opportunity for investment by U.S. plans.

With governmental, church, and foreign plans no longer at issue, more entities will be able to satisfy the 25% Test and will not be required to comply with the more complex requirements applicable to venture capital operating companies and real estate operating companies ("VCOCs" and "REOCs," respectively).

Even for an entity that remains unable to satisfy the modified 25% Test, the PPA offers some relief. Under prior law, once 25% or more of any class of equity interests in an entity (other than an insurance company general account) was held by benefit plan investors, all of its assets were regarded as plan assets when it invested in another entity. However, the PPA changes that result in a subtle but significant way by moving away from an "all-or-nothing" allocation of plan investments to a proportional approach. Under Section 611(f) of the PPA, an entity will only be considered to hold plan assets to the extent of the percentage of the equity interests owned by benefit plan investors. For example, under the new proportional approach, if 35% of the equity interests in a fund are held by benefit plan investors, and that fund subsequently makes a downstream investment in a second fund, the second fund is required to count only 35% of the first fund’s investment as plan assets for purposes of running its own 25% Test. Under prior law, the second fund would have to count 100% of the first fund’s investment as plan assets, even though only 35% of the first fund’s equity interests were held by benefit plan investors. This change offers a further avenue for avoiding unexpected ERISA coverage resulting from benefit plan investment.

Both ERISA and the Code prohibit many transactions between plans and "parties in interest".⁵ These transactions involve potential conflict of interest and self-dealing situations where a party in interest might act in a manner contrary to the best interests of the plan and its participants. Section 611(d) of the PPA creates a new statutory exemption to these rules, allowing eligible parties in interest to more freely conduct business with plans without the administrative hassles that were frequently at issue under prior law.

ERISA’s definition of "party in interest" is quite broad and sweeps up many persons and entities that are commonly involved in the operation of plans and the investment and management of their assets. Among the parties in interest subject to these prohibitions are persons or entities providing services to a plan. Plans often use multiple service providers ranging from investment advisors to trust companies to recordkeepers; many of these service providers are affiliates of much larger financial services companies, which are themselves often classified as parties in interest by virtue of these affiliate relationships. As a result of the factual complexity involved in many of these situations, avoiding inadvertent prohibited transactions with service providers has been costly and administratively cumbersome as plans and service providers attempt to conform their operations to one or more of the prohibited transaction class exemptions issued by the DOL or else seek their own individual prohibited transaction exemptions.

Under the new statutory exemption created by the PPA, if a person or entity is not a fiduciary (or an affiliate of a fiduciary) possessing discretionary authority or control over the investment of plan assets or providing investment advice for a fee to the plan at issue and is only a party in interest as a result of providing services to the plan, several common transactions involving the plan’s assets will no longer be prohibited as long as the plan does not receive less or pay more than "adequate consideration." The PPA provides some useful clarification on the "adequate consideration" issue by allowing factors such as the size of the transaction and the marketability of the securities at issue to be taken into consideration. Further, the exemption makes clear that any plan fiduciary can make "adequate consideration" determinations for transactions involving assets for which no public market exists (subject, of course, to the usual prudence and exclusive benefit requirements imposed on fiduciaries by ERISA).

The types of transactions covered by the new exemption include sales, leasing, and exchanges; lending of money or extension of credit; and transfers to or use by or for the benefit of service provider/parties in interest of benefit plan assets.⁶ This exemption permits many common transactions that were previously required to be conducted through a qualified professional asset manager under DOL class exemption 84-14.

Section 612 of the PPA creates a statutory prohibited transaction exemption applicable to a transaction involving the acquisition, holding, or disposition of any security or commodity if the transaction is corrected quickly after it is identified as problematic. The "correction period" for such transactions is the 14-day period beginning on the date that the transaction is identified as prohibited (or at the time it could have reasonably been identified as such). Under the new exemption, a "correction" will entail unwinding the transaction to the extent possible and making good any losses to the benefit plan and disgorging any related profits. The exemption is coordinated with the Code such that a transaction corrected under the exemption will not trigger an excise tax under Section 4975 of the Code.

As with the service provider exemption, the "correction" exemption is not applicable to fiduciary self-dealing transactions nor does it apply to transactions between a plan and plan sponsor involving employer securities or real property. The exemption is also not available to correct transactions that the fiduciary or party in interest knew or reasonably should have known were prohibited.

• Assess current levels of benefit plan participation in light of the narrowed definition of "benefit plan investor."

• Entities that currently satisfy the 25% Test should consider taking advantage of their now enhanced capacity to accept additional investments by ERISA plans and IRAs.

• Entities that are currently subject to ERISA by virtue of their "significant" benefit plan participation should reconsider their status in order to determine if their assets continue to be subject to ERISA under the look-through rule. This may require a review of existing partnership and subscription agreements, private placement memoranda, and other organizing documents.

• Determine the impact of the new definition for any upstream and downstream investors and make appropriate modifications.

• For entities operating as VCOCs or REOCs, managers should consider whether this status should be preserved going forward.⁷

• Review existing arrangements involving the provision of services to benefit plans to determine the applicability of the new service provider exemption and make appropriate modifications to service provider and related agreements.

• Service providers should reassess existing practices, trading restrictions, forms, and disclosures to take advantage of the new exemption.

Monitor plan asset transactions going forward to ensure that any prohibited transactions eligible for correction are quickly identified and corrected under the new statutory exemption.

The provisions of the PPA discussed above are generally effective as of the following dates:

• Revised Benefit Plan Investor Definition: Effective upon the enactment of PPA.

• Proportional Allocation of Benefit Plan Investments: Effective upon the enactment of PPA.

• Service Provider Exemption: Effective for transactions occurring on or after the PPA’s enactment date.

• Prohibited Transaction Correction Exemption: Effective for transactions which are discovered (or reasonably should have been discovered) on or after the PPA’s enactment date.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved