2008 ANNUAL SPRING INVESTMENT FORUM American College of Investment Counsel Chicago, IL

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1 2008 ANNUAL SPRING INVESTMENT FORUM American College of Investment Counsel Chicago, IL At the end of the Day (Les Miserables) ERISA 11:30am 12:30pm April 17, 2008 PANELISTS: Lennine Occhino Mayer Brown LLP Cheryl Denney White The Prudential Insurance Company of America

2 At the End of the Day... ERISA for Private Placement Lawyers Presentation to ACCI on April 17, 2008 By Lennine Occhino and Cheryl Denney White

3 What is ERISA (And Why Should I Care)? What is ERISA? US federal law enacted in 1974 Regulates management of employee benefit plans Prohibits certain plan investments and transactions Requires funding of traditional pension plans and creates back-up insurer for those plans Why Should I Care? Because it matters legally and financially to your clients and their deals

4 ERISA s Impact ERISA Effects on the issuer Effects on the investor Effects on private funds As investor in private securities (our primary focus today) As issuer of private securities (e.g., CDO, CLO, REMIC)

5 ERISA Analysis for Private Placements Does ERISA apply? Yes,, if plan assets involved Where are the ERISA plans or plan assets? Issuer? Investor? Private fund? What transactions involve plan assets? If transactions prohibited by ERISA, what exemptions are available?

6 ERISA s Impact on Issuer Key Questions: Does the issuer sponsor ERISA plans? Traditional pension plans If If issuer has plan, what type and how well funded? Union pension plans (i.e., collectively bargained) Defined contribution plans (e.g., 401(k) plans) Welfare benefit plans (e.g., providing health and medical, group life, disability and similar non-pension benefits) especially retiree medical benefits If so, how well funded are they? Are Are the issuer s assets ERISA plan assets?

7 What Plans Are Covered by ERISA? ERISA covers retirement or welfare benefit plans of: US employers engaged in inter-state commerce US unions, especially plans collectively bargained between union and employers ( multi-employer plans ) ERISA does not cover plans of: US federal, state or local governments Churches that don t elect to be covered Non-US employers with primarily non-us workers (so foreign issuers generally do not sponsor ERISA plans)

8 Employer Funding Obligations ERISA does not require employer to have a plan, but employer sponsoring a pension plan must fund it Funding levels now required to be shown on issuer s GAAP accounting statements Important to note actuarially computed liabilities for those benefits that continue beyond current employment year: Defined benefit pension plan funding level Retiree medical benefits funding level

9 Union Plan Withdrawal Liability Multi-employer plan obligations: Pay contributions required by collective bargaining agreement, at a minimum Pay withdrawal liability upon complete withdrawal or partial withdrawal (e.g., by reduction in union workforce) from multi-employer plan Computed as share of plan s total under-funding Can exceed aggregate contributions required under collective bargaining agreement Can be required even if all bargained contributions were paid in full

10 PBGC Liability ERISA Title IV created Pension Benefit Guaranty Corporation as back-up insurer for terminating pension plans Funded by annual premiums paid by plans/employers PBGC has rights to: Force termination of substantially under-funded plans Impose lien on assets of plan sponsor and its affiliates (under common control), up to 30% of net worth, to cover plan s under- funding Have priority of federal tax lien in bankruptcy proceedings

11 Issuer s ERISA Representations (see ACIC Model Form 1, Section 5.12) For issuer s plans: Any plan of issuer or affiliates is in compliance with applicable laws, with no material liability for Under-funding of plan Fiduciary violations/prohibited transactions No PBGC liens for issuer or its ERISA affiliates No multi-employer plan withdrawal liability Post-retirement benefit funding liability not material Financing is not prohibited transaction

12 ERISA s Impact on Investors Investor s ERISA representation: source of funds See ACIC Model Form 1, Section 6.2 Key question: Is investor using plan assets? Investing for bank? Investing for insurance company general account? Investing for insurance company separate account? Investing for private fund?

13 When Do You Have Plan Assets? General rule: : When plan makes an equity investment in another entity: The plan s stock certificate, partnership interest, contract, etc., is plan asset The entity s assets also become plan assets (the look through rule)

14 Avoiding Plan Assets: Exceptions to the Look-Through Rule Plan s investment is pure debt (not deeply subordinated nor with any equity features) Plan s investment is equity in: US mutual fund a publicly traded company (for its publicly traded classes of securities) an operating company, VCOC or REOC Equity participation by all benefit plan investors in entity is not significant (the 25% test)

15 When Do You Have Plan Assets? Issuer? usually not Issuer typically is an operating company, directly or through subsidiaries engaged in production or sale of a product or service Issuer may be publicly traded BEWARE: 25% or more of issuer may be owned by plan (e.g., ESOP) Bank (for its commercial funds)? - almost never Typically bank deposits are debt, not equity Capital investment in bank stock by plans may be less than 25% Bank may be publicly traded

16 When Do You Have Plan Assets? (continued) Insurance company general accounts? - usually Larger US life insurance companies typically represent that ERISA plan assets constitute less than 25% of their assets (since Supreme Court ruled in John Hancock v. Harris Trust in 1993) Insurance company separate accounts or bank collective trust accounts? - almost always Exception for fully guaranteed separate accounts where plan receives guaranteed return not investment returns Exception if investment limited to non-erisa plans Private funds? - it depends

17 If Plan Assets, Then What? Must meet ERISA s fiduciary standards: Act for exclusive benefit of plan participants Perform all duties as prudent expert would Diversify investments to minimize risk of large losses Act in accordance with plan documents... and avoid prohibited transactions

18 Prohibited Transactions Prohibitions Penalties and consequences Exemptions

19 Two Categories 1. Fiduciary prohibited transactions, which arise in conflicts of interest 2. Party-in in-interest interest prohibited transactions

20 Fiduciary Prohibited Transactions Self-dealing with plan assets Conflict of interest in acting for the plan Receiving payments (ERISA kickbacks ) from third parties related to transactions involving plan assets (e.g., fiduciary receiving loan origination fee from issuer based on investment by plan whose assets fiduciary manages)

21 Example: Insider Trading Fiduciary learns material, nonpublic information in connection with plan investment in an issuer and uses it to trade in issuer s securities in his own account self dealing conflict of interest

22 Example: Conflict of Interest Fiduciary investment manager represents two different clients. ERISA client invests in senior debt, the other in subordinate debt in same issuer. Because of the conflict of interest, fiduciary could not: Approve inter-creditor agreement. Represent ERISA account on issuer default.

23 Consequences of Prohibited Transaction to Fiduciaries Fiduciaries in prohibited transactions may incur: Excise taxes under IRC 4975 or ERISA 502 (from 15% to 100% of amount involved in transaction, plus interest) Inability to enforce contract (contract voidable as against public policy due to violation of federal law) or forced unwinding of transaction Plus, fiduciary would be liable for fiduciary breach: Personal liability to make up plan losses or repay profits made Court costs and attorneys fees if lose lawsuit 20% penalty if DOL sues (and wins or settles) Equitable relief, including removal from serving as plan fiduciary or being barred from dealing with plans altogether

24 Party-in in-interest Prohibited Transactions Prohibited, if direct or indirect: sale, exchange or lease of property loan or extension of credit furnish goods, services, or facilities transfer of plan assets to a party-in in-interest, interest, or use of plan assets by or for the benefit of a party-in in- interest to plan

25 Who Are Parties-in-Interest? PLAN

26 Officers & Employees of the Plan Employer or Union PLAN Fiduciary or other Service Provider

28 Example: Secondary Purchase ERISA plan account buys note of issuer on secondary market, from broker-dealer. Issuer co-invests in joint venture with employer sponsoring plan. Broker- dealer s parent also owns investment manager used by plan for another account. Potential prohibited transactions? Sale between plan and party in interest (broker) Loan between plan and party in interest (issuer)

29 Example: Takeout Financing ERISA account buys notes in financing, and issuer uses proceeds of note issuance to repay existing loan to bank. Bank is parent of one of ERISA plan s other investment managers. Prohibited transaction? Transfer Transfer of plan assets to a party-in in-interestinterest

30 Consequences of Prohibited Transaction to Parties in Interest Sellers, borrowers and others in transactions with ERISA plans may be parties in interest If prohibited transaction occurs, and no exemption is available, they may incur: Excise taxes under IRC 4975 or ERISA 502 (from 15% to 100% of amount involved in transaction, plus interest), which can pyramid over time Inability to enforce contract (contract voidable as against public policy due to violation of federal law) or forced unwinding of transaction Liability under contract provisions (e.g., default on violation of representations, indemnification)

31 Prohibitions on Employer Securities and Real Property Maximum investment of 10% of total plan assets in sum of qualifying employer securities and qualifying employer real property Qualifying employer securities will be stocks or marketable obligations, and can only be acquired if conditions met Qualifying employer real property is real estate purchased from and leased back to employer Exception for employer stock in 401(k) plans Potential problem if the plan of an issuer or its affiliates invest in the issuer s financing

32 Exemptions from Prohibited Transactions Statutory Administrative

33 Service Provider Exemption New statutory exemption added to ERISA by PPA 2006 Plan can enter transaction with service provider or affiliate for adequate consideration Service provider cannot be party with discretion over investment of plan assets involved in transaction or party giving investment advice on those assets Adequate consideration generally means fair market value, arms-length terms Transaction cannot be the provision of services

34 Administrative Class Exemptions Granted by DOL Can be relied upon by any party that can meet the conditions of the exemption Immediately available (rather than the delay necessary to obtain an individual exemption)

35 Exemption 95-60: Insurance Company General Accounts Exemption permits transactions between insurance company general account and parties in interest to plans that may have assets in the general account Permits investments in private placements without limiting to top ratings category for securities (as for other ERISA plan investors) Does not cover transactions with insurer s affiliates

36 Exemption 90-1: Pooled Separate Accounts Insurance company pooled separate account can enter transaction with party-in in-interest interest to a plan invested in the account: If plan s interest in account does not exceed 10% (if short term investments, no 10% rule) If party-in in-interest interest is only a service provider (not employer or affiliate), even if plan over 10% in interest Party in interest cannot be the insurer of the separate account or any affiliate Parallel exemption, PTE 91-38, for bank collective trust funds

37 Exemption 84-14: QPAM Qualified Professional Asset Manager Plan can enter transactions with parties-in in-interest interest ( PII ) if plan assets managed by a QPAM, if: PII cannot be the QPAM or its affiliates Assets of that plan cannot be 20% or more of all assets managed by the QPAM PII cannot have authority to hire or fire QPAM (for plans holding 10% or more of investment fund) QPAM must negotiate transaction for plan Transaction must be on arm s-length terms Similar In-HAM exemption PTE available for certain in-house registered investment advisors of large plans

38 ERISA s Impact on Private Funds Key question: how to avoid having plan assets? Know your investors (the significant benefit plan investor 25% test ) Know your investments (the operating company exceptions) Know your securities laws (the mutual fund and publicly traded company exceptions)

39 Avoiding Plan Assets: Operating Company An operating company is: a company primarily engaged, directly or through majority-owned owned subsidiaries, in the production or sale of a product or service other than investment of capital a venture capital operating company (VCOC) a real estate operating company (REOC)

40 Qualifying as a VCOC More than 50% of VCOC assets must be invested in operating companies For this purpose, assets valued at cost Excludes cash or short-term term holdings pending first long- term investment or liquidation/distribution of assets May not invest in other VCOCs,, but may invest in REOCs Must obtain and actively exercise significant management rights over operating company Board membership is the gold standard for rights, but can include ability to consult with management; often documented by side letters

41 Qualifying as REOC more than 50% of REOC assets must be invested in interests in real estate (fee title, leasehold, mortgage with conversion rights) Assets valued at cost excludes cash or short-term term holdings pending first long-term investment or liquidation/distribution of assets May be indirect holdings, through wholly owned sub must obtain and exercise significant management rights with respect to real estate (e.g.,( no triple net leases where tenant has the maintenance obligations)

42 Qualifying for VCOC/REOC Status Initial testing on closing of first permanent investment Do or die - qualify on first investment or never qualify Escrow in advance of initial investment is still plan assets Annual testing thereafter Annual testing period of 90 days, beginning upon anniversary of initial investment date Must meet test for one day in annual period

43 Avoiding Plan Assets: Significant benefit plan participation If benefit plan investment in any class of equity in private fund is 25% or less, fund s assets are not plan assets Benefit plan investors? YES: : ERISA plans, ERISA % of US insurance co. general accounts, ERISA % of private funds with over 25% ERISA plan investment in any class of equity NO: : non-us plans, US governmental plans, most non-us insurance companies, non-erisa private funds 25% of what? Deduct all interests held by asset manager and its affiliates Add back the ERISA asset % from insurer s general account, if insurer is entity s manager or affiliate

44 Example: 25% Test Entity s proposed capital $5 Existing Senior Debt $10 Existing Mezzanine Debt ERISA Plan Trust Account 50% 50% Bank Hedge Fund 50% 50% Bank $10 Preferred Stock $50 Common Stock Insurer General Account ERISA Account 30% 20% 50% Entity's Management Insurer General Account ERISA Account 40% 10% 50% Entity's Management

45 Summary: ERISA s Impact On the issuer: Impact of ERISA plan funding on financials Priority of government claims On the investor: Enforceability of transactions Penalties on prohibited transactions and/or fiduciary breaches if plan assets On private funds: Avoiding ERISA: Limits on investors or operations Subject to ERISA: Limits on investments and operations

46 Questions?

ERISA Considerations in Structuring Credit Facilities with Private Investment Funds

Presenting a live 90-minute webinar with interactive Q&A ERISA Considerations in Structuring Credit Facilities with Private Investment Funds WEDNESDAY, AUGUST 15, 2018 1pm Eastern 12pm Central 11am Mountain