Basics of ERISA Coverage

The Employee Retirement Income Security Act of 1974, as amended (ERISA) imposes numerous duties on fiduciaries holding employee benefit plan assets.  This includes the manager of a private equity fund who is responsible for investing the assets of a fund that holds plan assets.  Failure to follow fiduciary duties can result in lawsuits, Department of Labor (DOL) investigations and penalty taxes, for which fiduciaries may be personally liable.

Under ERISA, individuals who i) exercise authority or control respecting the management or control of ERISA plan assets, or ii) give investment advice for a fee or other compensation with respect to the assets of an ERISA plan, or have any authority or responsibility to do so, is an ERISA fiduciary. 

Fiduciaries who violate ERISA’s standards may be personally liable to restore plan losses, disgorge profits made through the use of plan assets, and pay additional statutory penalties imposed by the DOL.  The fiduciary may also face criminal penalties if found guilty of wilful failure. 

In addition to the duty to avoid “prohibited transactions”, which is described in more detail below, ERISA imposes the following obligations on fiduciaries:

• Duty of Loyalty:  An ERISA fiduciary must act “solely in the interest” of ERISA plan participants and with an “eye single” to their interests. 

• Duty of Care:  ERISA fiduciaries must act with the care, skill and diligence that a prudent person, acting in a like capacity and familiar with such matters, would use in similar circumstances. 

• Duty to Diversify Plan Assets:  ERISA fiduciaries must diversify plan assets unless, under the circumstances, doing so is clearly imprudent.  Fund managers should be careful to include language in offering documents stating that the duty to diversify is limited to the fund’s specific investment mandate, and does not apply to the plan’s overall portfolio. 

• Duty to Follow Plan Documents:  ERISA fiduciaries must follow the terms of the benefit plans for which they serve as fiduciaries.  A subscription agreement for a benefit plan investor should include a notice that the investment in the private equity fund is permitted under plan documents and complies with ERISA.  Managers of funds in which benefit plans have invested should independently review the plan documents. 

• Duty with Respect to Co-Fiduciaries:  A fiduciary cannot i) knowingly participate in or conceal another fiduciary’s breach, ii) enable another fiduciary to commit a breach, or iii) know of another fiduciary’s breach and not make reasonable efforts to remedy it.  A fiduciary, such as a fund manager, may be required to take action under ERISA if it learns that other plan fiduciaries have violated their duties.

Duty to Avoid Prohibited Transactions

ERISA prohibits fiduciaries, such as managers of a fund that holds plan assets, from engaging in transactions with “parties in interest” to the ERISA plan that invests in the fund, unless an exemption exists.  Parties in interest include the plan’s service providers, such as accountants, attorneys, brokers and dealers with whom the plan conducts business, and certain other persons.

ERISA prohibits a variety of transactions between a plan and a party in interest, including

• The sale, exchange or leasing of property

• The lending of money or extension of credit

• The transfer or use of plan assets.

While exemptions to the party in interest rules exist, there are many nuances to these exemptions and the circumstances under which they are available.  Managers who wish to take advantage of the exemptions should therefore review them carefully before taking any action. 

Specific Tasks Required Of Fiduciaries

ERISA requires that fiduciaries undertake certain specific tasks, including providing fee disclosures to participants and filing annual reports with the Internal Revenue Service.  They are also required to ensure that plan assets be kept within the jurisdiction of US courts and that fund managers maintain a fidelity bond. 

How Private Equity and Hedge Funds Can, and Cannot, Avoid ERISA Coverage

If a private equity fund holds plan assets, fund managers will be plan fiduciaries unless one of ERISA’s exceptions applies.  The two most common exceptions are the insignificant participation exception and the operating company exception. 

The Insignificant Participation Exception

The insignificant participation exception states that, if plan assets are less than 25 per cent of any class of equity of a fund, the fund will not be deemed to hold plan assets.  When a new investor invests, the percentage held by benefit plan investors must be re-analyzed.

Identifying which assets count as benefit plan assets is not as straightforward as one might think.  For example, assets held by someone with discretionary authority, or control of a private equity fund, don’t count as non-plan assets in either the numerator or denominator of total equity.  Some benefit plans, such as government plans, foreign plans and so-called church plans can invest in hedge funds or private equity funds without any portion of their assets counting towards the 25 per cent limit.  The assets of some entities that aren’t subject to ERISA e.g., individual retirement account and Keogh plan assets, count towards the 25 per cent limit. 

When investors in equity funds use tiered investment structures, determining whether or not benefit plan investors hold 25 per cent of the fund’s equity can become trickier.  For example, suppose investors in a private equity fund with one class of equity held a total of US$500 million of equity, of which US$25 million was held directly by benefit plans, US$175 million was held by individuals, and US$300 million was held by another private equity fund.  Whether or not the US$500 million private equity fund holds plan assets depends on the makeup of the fund investing the US$300 million.  If benefit plan investors held US$75 million of that US$300 million, the fund investing the US$300 million would hold plan assets.  For the purposes of determining whether or not the US$500 million fund holds plan assets, however, only US$75 million of the US$300 million fund’s investment counts as plan assets.  A total of US$100 million of the US$500 million of equity, representing 20 per cent, is therefore plan assets and the US$500 million fund is not considered to hold plan assets. 

Equity with special redemption rights or management fee waivers might create a separate class of equity, as might the law applicable to the fund or the fund documents.  If a large benefit plan sought special redemption rights, which were not granted to any other investor, as a condition of investing, and those rights created another class of equity, benefit plan investors would hold 100 per cent of a class of the fund’s equity, resulting in the fund’s being considered to be holding plan assets.

The Venture Capital Operating Company Exception

ERISA provides that a venture capital operating company (VCOC) will not be deemed to hold plan assets.  In general, an operating company is an entity engaged primarily, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.  To be considered a VCOC for ERISA purposes, on the date of its first long-term investment and on at least one day during an annual, pre-established 90-day period, the entity must have at least 50 per cent of its assets invested in operating companies that provide it with “sufficient” management rights in those companies.  It must also exercise those rights during each 12 month period after the date of its first investment with respect to at least one operating company.

DOL guidance on what constitutes sufficient management rights is scarce, but management rights can include rights to appoint directors or officers to an operating company’s board, the right to examine its records, and other rights more significant than those typically found in the debt instruments of established, credit-worthy companies that are purchased privately by institutional investors.

A private equity fund seeking to qualify for the VCOC exception should try to obtain as many management rights as possible.  Generally, these rights are provided in a separate management rights letter issued by the operating company to the private equity fund.