How Benefit Plan Investments Can Trigger ERISA Fiduciary Rules for Fund and PE Managers

Observe the 25% Rule to Steer Clear
of Onerous Regulations

In today’s economy, with inflation concerns, interest rate fluctuations, and market volatility, alternative investments become attractive to many, including retirement plans governed by the Employee Retirement Income Security Act of 1974 (ERISA). This federal law governs most voluntarily established retirement and health plans in the private sector by setting minimum standards for participation, vesting, benefit accrual, and funding, in addition to ensuring transparency and fiduciary responsibility in their administration. Fund managers must navigate complex regulations when accepting investments from benefit plan investors subject to ERISA or Section 4975 of the Internal Revenue Code of 1986, which imposes a tax on certain prohibited transactions involving Individual Retirement Accounts (IRAs).

Of primary concern with benefit plan investors is the potential for hedge fund assets to cross a legal line and come to be considered “plan assets.” This happens if benefit plan investors own 25% or more of any class of equity in the fund, subjecting the fund managers to the fiduciary responsibilities and prohibited transaction provisions of ERISA and Section 4975. (Interests held by the fund manager and its affiliates are excluded from this calculation.)

It’s important to keep in mind that the 25% benchmark is an aggregate rule. In other words, even if no single benefit plan investor holds more than 25%, if all benefit plan investors collectively own more than 25% of any class of equity in a fund, the ERISA rules are triggered, defining the fund’s assets as plan assets and subjecting the fund managers to ERISA’s additional requirements and obligations.

A key point is that the 25% rule applies to all share classes individually.

For example, if Class A represents 90% of the fund/entity’s assets, and Class B represents 10% of the total fund equity asset, the fund could not have more than 2.5% of Class B shares owned by benefits or retirement plans.

Another example is a fund that has two classes of equity, with Class A representing 80% of the entity’s total equity, and Class B representing the remaining 20% of the entity’s total equity. If benefit plan investors own less than 25% of the Class A interests, but 25% or more of the Class B interests, the assets of the entire fund will be considered plan assets. This is true even though benefit plan investors own less than 25% of both the Class A interests and the total equity of the fund.

To avoid this issue, most hedge fund managers keep benefit plan investments below the 25% threshold. But that requires careful calculations, particularly when a benefit plan investor comes in with a large investment that changes the calculation as to what constitutes a 25% threshold.

Understanding Benefit Plan Investors

“Benefit plan investors” include employee benefit plans subject to Title I of ERISA (e.g., traditional U.S. private sector pension plans and 401(k) plans); individual retirement accounts (IRAs); Keogh plans; other plans or accounts subject to IRC Section 4975, and entities holding the plan assets of such plans or accounts.

Consequences of Holding “Plan Assets”

If a fund’s assets are considered “plan assets,” the manager must comply with the following additional requirements:

• Fiduciary duties: The manager must act as a fiduciary, adhering to duties of prudence, loyalty, diversification, and compliance with governing documents.
• Prohibited transactions: The manager must avoid non-exempt prohibited transactions, which can include dealings with affiliates or certain compensation structures.

Additionally, to manage a “plan asset” fund, the manager must register with the SEC as an investment adviser or be a U.S. bank or insurance company and acknowledge fiduciary status under ERISA in writing.

Additional considerations include:

• Indemnification: Managers generally cannot be indemnified out of for breaches of fiduciary duty.
• Transaction compliance: Managers must ensure all transactions comply with prohibited transaction rules or exemptions.
• QPAM qualification: Managers must qualify as a Qualified Professional Asset Manager (QPAM) to rely on broad prohibited transaction exemptions.
• Fidelity bonding: Managers must comply with ERISA’s fidelity bonding requirements.
• Asset ownership: Managers must ensure that, with limited exceptions, indicia of ownership of fund assets are held within the U.S.
• Reporting and disclosure: Managers must adhere to additional ERISA reporting and disclosure requirements.

How to Proceed

Funds that have an opportunity to receive a significant investment from an ERISA benefit plan investor, but doing so would exceed the 25% rule and subject it to ERISA and/or Section 4975 rules, it is strongly recommend seeking advice from an attorney and other service providers about how to proceed and ensure compliance.

For fund managers who are subject to the ERISA and/or Section 4975 rules, extreme care is required to avoid breaches of fiduciary duties or engaging in non-exempt prohibited transactions, as these can result in significant liabilities, including personal liability for losses, disgorgement of profits, and excise tax penalties.

By maintaining investments from benefit plan investors below the 25% threshold and adhering to these guidelines, hedge fund and private equity managers can effectively navigate ERISA and Section 4975 compliance. Consulting with ERISA counsel is also recommended to help ensure compliance with these onerous rules. For further information and guidance, please reach out to Alicja Mierzwa or your Anchin Relationship Partner.