ERISA Considerations: What Fund Managers Need to Know

The following discussion provides a general overview of how an investment company or partnership (hereinafter, a “fund”) and its principal investment manager may be impacted upon the acceptance of investor capital contributions (collectively, “benefit plan investors”), which are generally subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and parallel requirements in the Internal Revenue Code, as amended (“IRC”). The provisions of ERISA and the IRC are subject to oversight by the U.S. Department of Labor (the “DOL”) and the Internal Revenue Service, respectively. The Purpose behind ERISA ERISA is a complex piece of legislation enacted to regulate the establishment, operation, andrnadministration of employee benefit plans (“benefit plans”) as a means of protecting the intendedrnbeneficiaries of such benefit plans from abuses associated with imprudent investing and other problems, such as unfunded plans. To achieve its objective, ERISA imposes numerous obligations on fiduciaries of benefit plans and prohibits certain transactions involving conflicts of interests (the so-called “prohibited transactions”). When Does ERISA Apply to my Fund?rnThe ERISA provisions apply to a fund when two conditions are met: 1) benefit plan investors (defined below) are considered to hold a “significant” amount of the fund’s equity interest, and 2) at least one of those investors, no matter the size of their investment, is an employee welfare or pension benefit plan (defined below). Benefit plan investors are considered to hold a significant amount of a fund’s equity interest if they hold, in the aggregate, 25% or more of the value of any class of the fund’s equity interests (e.g., limited partnership interests). When Does ERISA Not Apply to my Fund?rnThe ERISA provisions will not apply to a fund when benefit plan investors hold, in the aggregate, less than 25% of the value of any class of the fund’s equity interests or when there are no employee welfare or pension benefit plans invested in the fund. However, the so-called “prohibited transactions” restrictions under the IRC (described below) will nonetheless apply if only one condition is met: benefit plan investors (defined below) are considered to hold a “significant” amount of the fund’s equity interest (i.e., the 25% threshold is met). Who are “Benefit Plan Investors”?rnGenerally speaking, benefit plan investors include 1) employee benefit plans which are subject to ERISA, 2) plans to which IRC Section 4975 applies, and 3) entities whose underlying assets include “plan assets.” 1) Employee benefit plans subject to ERISA include both “employee welfare benefit plans” andrn“employee pension benefit plans.” Employee welfare benefit plans are defined in ERISA Section 3(1) and generally include those plans which provide:rna. Medical, surgical, or hospital care or benefits, including, but not limited to, major medical, dental, vision, and prescription drug benefits; healthcare flexible spending accounts (Health FSAs); health reimbursement arrangements (HRAs), including premium reimbursement plans; and certain employee assistance programs (EAPs), wellness programs, disease-management programs, and cancer policies;rnb. Benefits in the event of sickness, accident, death, or unemployment, including insured disability income plans, insured sick-pay plans, accidental death and dismemberment (AD&D) plans, and life insurance plans;rnc. Funded vacation benefits;rnd. Funded apprenticeship or training benefits;rne. Day-care centers;rnf. Funded scholarship benefits;rng. Certain prepaid legal service arrangements;rnh. Severance and holiday benefits; andrni. Certain housing assistance benefits. Employee pension benefit plans are defined in ERISA Section 3(2) and generally include:rna. Defined benefit pension plans funded by an employer and guaranteeing a retirement benefit to the employee based on a number of factors, including his/her age, salary, and length of service; andrnb. Defined contribution pension plans, such as money purchase plans, profit sharing plans or stock bonus plans, employee stock ownership plans (ESOPs), Taft-Hartley plans, and 401(k) plans. Notably, certain plans are not covered by ERISA unless such plans explicitly opt in, including: rna. Federal, state, or local government plans or plans of certain international organizations;rnb. Church or church association plans;rnc. Plans maintained solely to comply with state worker’s compensation, unemployment, compensation, or disability insurance laws;rnd. Plans maintained outside the United States primarily for the benefit of nonresident aliens;rne. Certain private employer plans, commonly known as “top hat” plans, which provide deferred compensation to a limited number of management or other highly compensated employees; andrnf. Unfunded excess benefit plans, or plans maintained solely to provide benefits or contributions in excess of those allowable for tax-qualified plans. 2) IRC Section 4975 applies to the plans described in subsection 4975(e)(1) of the Code,rnincluding:rna. Individual retirement accounts (IRAs);rnb. Individual retirement annuities;rnc. Keogh plans;rnd. Health savings accounts (HSAs); andrne. Tax-exempt trusts. rn3) Entities may also be benefit plan investors if their underlying assets are plan assets. Commonly, this may occur in a fund of funds situation: if a fund of funds has an equity class, 25% or more of which is held by benefit plan investors, that fund of funds is a benefit plan investor in each of the funds in which it invests (limited to the percentage of which the fund of funds’ underlying assets are plan assets). For example, a fund of funds has one equity class of which 50% is held by benefit plan investors, making the fund of funds’ underlying assets “plan assets.” The fund of funds then invests $1 million in another fund, and is therefore considered a benefit plan investor in the amount of $500,000 (50% of the $1 million investment). This investment by the fund of funds may, in turn, trigger the 25% ERISA threshold for the fund in which it invests (see below). Monitoring the 25% Benefit Plan Investor Threshold To remain outside from the purview of ERISA and from the “prohibited transactions” restriction, a fund must ensure that its benefit plan investors do not hold 25% of any class of its equity interests at any moment. Class Distinctions- although the law remains vague on this point, it is advisable that the 25% threshold be observed for all classes of interests or shares in your fund (ie, Class A, Class B, etc.), even if there is no material difference between the classes. On the other hand, even if all the interests or shares of your fund belong to the same class, differences among investors or the series of interests or shares they hold may trigger the “class of equity” distinction. For example, a benefit plan investor signs a side letter agreement with the fund changing one or more of the material terms of the offering, though no new “class” of shares is created; nevertheless, this side letter may create a new de facto class of equity interests and violate the 25% threshold, triggering ERISA and/or the “prohibited transactions” restriction.