The Pension Protection Act of 2006 (H.R. 4), which was passed by the House of Representatives on July 28 and the Senate on August 3 and has been sent to the President for his signature, will significantly change how hedge funds and other private equity funds determine whether the assets they manage are subject to ERISA.
Under a provision of the regulations known as the "plan asset look-through rules," an investment fund generally is treated as holding ERISA plan assets, and is subject to the fiduciary and prohibited transaction rules of ERISA, if 25% or more of the value of any class of equity interests in the fund is held by "benefit plan investors." This rule does not apply to a registered investment company or an investment fund that satisfies the detailed requirements to be a venture capital operating company (VCOC) or real estate operating company (REOC).
Under current law, "benefit plan investors" means (1) benefit plans subject to ERISA, (2) benefit plans that would be subject to ERISA but for an exemption, (3) plans subject to section 4975 of the Internal Revenue Code (e.g., individual retirement accounts and health savings accounts), and (4) other investment funds that are themselves treated as holding assets of any of these plans because of the plan asset look-through rules (feeder funds). Benefit plans that are exempt from ERISA include (a) foreign plans, i.e., plans primarily for nonresident alien employees, (b) governmental plans, i.e., plans maintained by the U.S. government, a state or local government, or a political subdivision or agency or instrumentality of any of them, or an international organization such as the World Bank that is exempt from tax under the International Organization Immunities Act, and (c) church plans that have not elected to be subject to ERISA. Generally, if a feeder fund is treated as holding any plan assets, 100% of any investment it makes in another fund is treated as being made by a benefit plan investor, even if the percentage of its equity that is held by benefit plan investors is much less than that.
The Pension Protection Act of 2006 will change these rules in two important ways. First, it will require only benefit plans that are actually subject to ERISA or section 4975 of the Internal Revenue Code to be counted as "benefit plan investors" and thus will allow foreign plans, governmental plans, and non-electing church plans to be disregarded in calculating the 25% limit. Second, it will treat an investment by a feeder fund as made by a benefit plan investor only to the extent of the percentage of the equity in the feeder fund that is held by benefit plan investors. (An earlier version of the legislation also would have increased the 25% limit to 50%. However, that change was not made.) A separate provision of the Act also will treat plans maintained by Indian tribal governments as governmental plans.
The changes will apply to transactions occurring after the date of the enactment of the legislation, i.e., when the President signs it into law. That is expected to occur soon, possibly next week.
The changes potentially will allow investment funds to accept unlimited amounts of investments from foreign, governmental and non-electing church plans without, for example, qualifying as VCOCs or REOCs. However, the effect might not be immediate. For example, some governmental plans have investment guidelines requiring funds that are not VCOCs or REOCs to satisfy the current version of the 25% test, and will have to decide how to react to the changes. Also, because of the prospective effective date, it is not clear at this time to what extent the new rules will apply to an existing investment fund or existing investments held by such a fund. Even assuming they apply, the fund documents might limit its ability to take advantage of the new rules (for example requiring the manager to certify each year that the fund qualifies as a VCOC) unless the documents are amended. Furthermore, taking full advantage of the treatment of feeder funds will require more information about them than most funds currently collect, as well as more ongoing monitoring.
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