Pension Protection Act of 2006 Congress Makes it Easier to Satisfy the ERISA Plan Assets Regulation 25% Limit and Provides Much Needed Relief From Certain of the Prohibited Transaction Rules Under ERISA and the Code August 5, 2006 On August 3, 2006, the Senate passed H.R. 4, the Pension Protection Act of 2006 (the Act ) 1, which provides significant relief from certain of the plan asset and prohibited transaction rules under the Employee Retirement Income Security Act of 1974, as amended ( ERISA ), and the corresponding rules under the Internal Revenue Code of 1986, as amended (the Code ). The Senate passed H.R. 4 without amendment by a vote of 93-5, after the House had passed H.R. 4 by a vote of 279-131 on July 28, 2006. President Bush must now sign the bill in order for it to become law. This Stroock Special Bulletin provides an overview of the provisions of the Act relating to the plan assets regulation and certain of the prohibited transaction rules under ERISA and the Code. 2 ERISA s Plan Assets Regulation: 25% Benefit Plan Investor Limit Easier to Satisfy Governmental Plans, Church Plans and Foreign Plans No Longer Counted Under the Department of Labor s plan assets regulation (29 C.F.R. 2510.3-101), when an employee benefit plan subject to ERISA acquires a non-publicly traded equity interest in an entity in which there is significant investment by benefit plan investors, the underlying assets of the entity generally will constitute plan assets subject to ERISA, unless an exception to the plan assets regulation applies. Investment by benefit plan investors will be considered significant if, immediately after the most recent acquisition of any equity interest in the entity, twenty-five percent (25%) or more of the value of any class of its equity interests (disregarding the interests of the fund manager and certain affiliates) is held by benefit plan investors. Under pre-act law, the term benefit plan investors included both plans that were subject to ERISA and/or Section 4975 of the Code (e.g., private pension plans, individual retirement accounts, and entities whose assets included plan assets by reason of plan investment therein) as well as plans that were exempt from ERISA and Section 4975 of the Code (e.g., governmental plans, church plans and foreign plans). The Act changes the definition of benefit plan investor so that only plans subject to ERISA or Section 4975 of the Code (and entities whose assets are considered to include plan STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI 180 MAIDEN LANE, NEW YORK, NY 10038-4982 TEL 212.806.5400 FAX 212.806.6006 WWW.STROOCK.COM
assets by reason of plan investment therein) would be considered benefit plan investors (which would exclude governmental plans, church plans, and foreign plans). Private investment funds often target investments from both categories of plans (plans subject to ERISA and/or Section 4975 of the Code, and exempt plans), and therefore, to avoid being subject to ERISA s burdensome rules, such funds have had to be structured either (i) to limit investment by such plans to below the 25% limit or (ii) to qualify for some other exception to the plan assets regulation s look-through rules (which often has interfered with the investment objectives of the funds). 3 The Act will make it much easier for such funds to satisfy the 25% limit. In addition, funds that have stayed under the 25% limit may now be able to accept new investments from benefit plan investors. Illustration #1: Fund V has five investors, each of which owns 20% of the equity interests of Fund V. Investor A is a private pension plan that is subject to ERISA. Investor B is a governmental plan. Investors C, D and E are corporations. Pre-Act Law: Assuming Fund V does not qualify for any other exception to the plan assets regulation, the assets of Fund V would be considered plan assets subject to (Investors A and B) own 25% or more (40%) of the equity interests of Fund V. Under the Act: The assets of Fund V would not be considered plan assets subject to (Investor A) own less than 25% (20%) of the equity interests of Fund V. Investor B would not be considered a benefit plan investor under the Act because governmental plans are no longer considered benefit plan investors. Pro Rata Test For Investing Entities Holding Plan Assets Under pre-act law, if investment by benefit plan investors in an entity equaled or exceeded the 25% limit (and therefore, such entity was considered to hold plan assets subject to ERISA), 100% of its investment in another entity would be considered to be an investment by a benefit plan investor. The Act provides that an entity will only be considered to hold plan assets to the extent of the percentage of the equity interests held by benefit plan investors. In other words, if less than 100% of the equity interests of an entity are owned by benefit plan investors, then only a pro rata portion of such entity s investment in another entity will be considered an investment by a benefit plan investor. Illustration #2: Fund W has five investors, each of which owns 20% of the equity interests of Fund W. Investors A and B are private pension plans that are subject to ERISA. Investors C, D and E are corporations. Fund W invests $100,000 of its assets in Fund X. Pre-Act Law: Assuming Fund W does not qualify for any other exception to the plan assets regulation, the assets of Fund W would be considered plan assets subject to (Investors A and B) own 25% or more (40%) of the equity interests of Fund W. X is below the 25% benefit plan investor limit, 100% of Fund W s $100,000 investment in Fund X ($100,000) would be considered an investment by a benefit plan investor. Under the Act: Once again, the assets of Fund W would be considered plan assets subject to ERISA (assuming Fund W does 2
not qualify for any other exception to the plan assets regulation), because benefit plan investors (Investors A and B) own 25% or more (40%) of the equity interests of Fund W. X is below the 25% benefit plan investor limit, however, only 40% of Fund W s $100,000 investment in Fund X ($40,000) would be considered an investment by a benefit plan investor because of the new pro rata rule under the Act. Illustration #3: Fund Y has five investors, each of which owns 20% of the equity interests of Fund Y. Investors A and B are private pension plans that are subject to ERISA. Investor C is a foreign plan. Investors D and E are corporations. Fund Y invests $100,000 of its assets in Fund Z. Pre-Act Law: Assuming Fund Y does not qualify for any other exception to the plan assets regulation, the assets of Fund Y would be considered plan assets subject to (Investors A, B and C) own 25% or more (60%) of the equity interests of Fund Y. Z is below the 25% benefit plan investor limit, 100% of Fund Y s $100,000 investment in Fund Z ($100,000) would be considered an investment by a benefit plan investor. Under the Act: Once again, the assets of Fund Y would be considered plan assets subject to ERISA (assuming Fund Y does not qualify for any other exception to the plan assets regulation), because benefit plan investors (Investors A and B) own 25% or more (40%) of the equity interests of Fund Y. Investor C would not be considered a benefit plan investor under the Act because foreign plans are no longer considered benefit plan investors. Z is below the 25% benefit plan investor limit, however, only 40% of Fund Y s $100,000 investment in Fund Z ($40,000) would be considered an investment by a benefit plan investor because of the new pro rata rule under the Act. Prohibited Transaction Rules Under ERISA and the Code Relief Provided for Certain Transactions Relating to Financial Investments Section 406 of ERISA and Section 4975 of the Code prohibit a plan from engaging in certain transactions involving plan assets with persons that are parties in interest under ERISA or disqualified persons under the Code with respect to the plan. There are statutory exemptions for certain types of transactions, and the Department of Labor may grant exemptions with respect to particular transactions or classes of transactions after consultation and coordination with the Secretary of Treasury. The Act provides new statutory exemptions for certain transactions relating to financial investments that otherwise would be prohibited under ERISA and the Code. The new statutory exemptions provided by the Act will obviate the need to rely on an otherwise applicable prohibited transaction class exemption (such as the QPAM exemption) as to transactions that are covered by any of the new statutory exemptions. Service Provider Exemption The Act provides a statutory prohibited transaction exemption under ERISA and the Code for certain transactions (such as sales of property, loans, and transfers or use of plan assets ) between a plan and a person who is a party in interest to the plan 3
solely by reason of providing services to the plan, but only if the plan neither receives less, nor pays more, than adequate consideration in connection with the transaction. The exemption does not apply to a fiduciary or an affiliate thereof that has or exercises discretionary authority or control over the investment of the plan s assets involved in the transaction or that renders investment advice with respect to those assets. Adequate consideration generally is defined as follows: (i) with respect to a security for which there is a generally recognized market, the price of the security listed on a national securities exchange, or if not so listed, a price not less favorable to the plan than the offering price for the security as established by the current bid and asked prices quoted by persons independent of the issuer and the party in interest, and (ii) with respect to an asset other than a security for which there is a generally recognized market, the fair market value of the asset as determined in accordance with regulations to be prescribed by the Department of Labor. Other Exemptions In addition, the Act provides new statutory exemptions from the prohibited transaction rules under ERISA and the Code for the following: Block Trades: certain transactions involving the purchase and sale of securities or other property between a plan and a party in interest (other than a fiduciary) involving a block trade (i.e., a trade of at least 10,000 shares or with a market value of at least $200,000 that will be allocated across two or more unrelated clients of a fiduciary); Cross Trades: certain transactions involving the purchase and sale of a security between a plan and any other account managed by the same investment manager; Electronic Communication Network: certain transactions involving the purchase or sale of securities between a plan and a party in interest if the transaction is executed through an electronic communication network, alternative trading system, or similar execution trading venue that is subject to Federal (or if applicable, foreign) regulation and oversight; and Foreign Exchange Transactions: certain foreign exchange transactions between a bank or broker-dealer (or affiliate of either) and a plan in connection with the sale, purchase, or holding of securities or other investment assets. Bonding Relief Subject to certain exceptions, ERISA generally requires a plan fiduciary and any person handling the assets of a plan to be bonded, generally in an amount between $1,000 and $500,000 depending on the amount of funds handled by such person. The Act provides an exception to the bonding requirement for an entity registered as a broker or dealer under the Securities Exchange Act of 1934 if the broker or dealer is subject to the fidelity bond requirements of a self-regulatory organization. This relief is effective for plan years beginning after the date of enactment of the Act. Effective Date As noted above, President Bush must sign the Act in order for it to become law. Once that has happened, the provisions of the Act described in this Stroock Special Bulletin will be applicable to any transactions occurring after the date of enactment of the Act (except where specifically stated otherwise with respect to bonding relief). 4
For further information regarding this Stroock Special Bulletin or the Act, contact Stroock s Employee Benefits Practice Group: Mark Wintner 212.806.6020 (mwintner@stroock.com) Laurel Rotker 212.806.5980 (lrotker@stroock.com) Abbey Keppler 212.806.5845 (akeppler@stroock.com) Adam Scoll 212.806.5515 (ascoll@stroock.com) Marissa Holob 212.806.5650 (mholob@stroock.com) 1. The full text of the Act can be found at http://www.house.gov/ed_workforce/issues/109th/ workforce/pension/pension.htm. 2. The Act also provides for comprehensive reform of the U.S. pension system that this Stroock Special Bulletin does not address. If you have any questions regarding the provisions of the Act relating to pension reform, please feel free to contact any of the persons listed at the end of this Stroock Special Bulletin. 3. In order to avoid being subject to ERISA s fiduciary responsibility rules and the prohibited transaction rules under ERISA and the Code, private investment funds that accept investments equal to or above the 25% limit from benefit plan investors often are structured and operated in a manner that enables them to qualify for the venture capital operating company (VCOC) exception to the plan assets regulation s look-through rules. However, operating a fund as a VCOC may limit the fund from making certain types of investments that it would otherwise have made if the fund were not seeking to maintain its status as a VCOC. 5
New York 180 Maiden Lane New York, NY 10038-4982 Tel: 212.806.5400 Fax: 212.806.6006 Los Angeles 2029 Century Park East Los Angeles, CA 90067-3086 Tel: 310.556.5800 Fax: 310.556.5959 Miami Wachovia Financial Center 200 South Biscayne Boulevard, Suite 3100 Miami, FL 33131-5323 Tel: 305.358.9900 Fax: 305.789.9302 www.stroock.com This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan LLP 2006 Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted. This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. Stroock & Stroock & Lavan LLP is a law firm with a national and international practice serving clients that include investment banks, commercial banks, insurance and reinsurance companies, mutual funds, multinationals and foreign governments, industrial enterprises, emerging companies and technology and other entrepreneurial ventures. For further information about Stroock Special Bulletins, or other Stroock publications, please contact Richard Fortmann, Senior Director-Legal Publications, at 212.806.5522.