US DOL regulations may challenge private investment funds.

Abstract

Purpose--The purpose of this paper is to analyze recent regulations and proposed regulations issued by the US Department of Labor (DOL) that relate to the reporting of compensation paid to service providers to employee benefit plans.

Design/methodology/approach--The paper reviews the statutory provisions of the Employee Retirement Income Security Act of 1974, as amended (ERISA), applicable DOL regulations as available in the Federal Register and certain public comments and a DOL FAQs document regarding the applicable regulations available on the DOL's web site. The paper also reties on observations of common market practice based on actual experience.

Findings--Recent DOL regulations--in particular those related to Form 5500 reporting and the "Necessary Services Exemption"--may significantly affect the reporting obligations of certain private investment fund sponsors with respect to their employee benefit plan investors. It shows that, although the scope of these regulations is understandable in the context of participant-directed defined contribution plans, they may be less so in the context of defined benefit plans, which invest more frequently in private investment funds. There are some potential exceptions, on which private investment fund sponsors may be able to rely. Achieving compliance with the rules as drafted, however, may be time-consuming and costly.

Practical implications--Private investment fund sponsors may wish to begin looking at their compensation and service provider arrangements in light of these regulations and consider how best to respond.

Originality/value--The paper contains two experienced ERISA practitioners' analysis of recent regulations on which relatively few stakeholders have seemed to focus to date.

Keywords Disclosure, United States of America, Regulation, Financial reporting

Paper type Viewpoint

I. Introduction

For many private investment fund sponsors, the decision to accept corporate employee benefit plan capital has required little more than structuring a fund's operations to avoid substantive regulation under the Employee Retirement Income Security Act of 1974, as amended (ERISA). Many fund sponsors, therefore, are very familiar with the rules that exempt funds from compliance with the statue's substantive rules-i.e. ERISA's "Plan Assets Regulation," [1] its "25% test," and its rules related to "venture capital operating companies" (VCOCs) and "real estate operating companies" (REOCs). In general, funds that comply with these exceptions (Non-Plan Asset Vehicles) have allowed their managers to avoid ERISA's fiduciary liability provisions, prohibited transaction rules and various other requirements (such as ERISA's bonding, indicia of ownership and reporting and disclosure requirements).

Based on a series of regulatory guidance that the US Department of Labor (DOL) began issuing in 2006, however, accepting capital from employee benefit plans that are subject to ERISA (Plans) [2] may soon subject sponsors of Non-Plan Asset Vehicles (in particular, sponsors of so called "Under 25 percent Funds") to a new set of complex challenges. From the Non-Plan Asset Vehicle sponsor's perspective, these changes can be traced to a redefinition of certain core principles that date back to the enactment of ERISA and shortly thereafter.

II. Brief ERISA primer

To understand the import of the DOL's recent guidance, one must first become familiar with certain basic ERISA rules that managers typically seek to avoid by establishing their funds as Non-Plan Asset Vehicles.

A. ERISA's fiduciary and prohibited transaction rules

When it comes to the investment of pension plan assets, ERISA has two key categories of substantive requirements: its fiduciary rules and its prohibited transaction rules.

ERISA's fiduciary rules generally require a plan fiduciary to act solely in the interest of the participants and beneficiaries of the Plan and for the exclusive purposes of providing benefits and defraying reasonable expenses of administering the Plan. A fiduciary must also act with the care of a "prudent expert," seek to minimize large losses by diversifying a plan's investments and act in accordance with the governing documents of the Plan [3]. None of the pending changes impose these requirements on managers of Non-Plan Asset Vehicles.

ERISA's prohibited transaction rules come in two varieties-"self dealing" transactions and "party in interest" transactions [4]. The former, as the name suggests, prohibit certain acts of fiduciary self dealing and are not necessarily affected by the new regulations described below. The "party in interest" prohibited transaction rules absolutely prohibit a broad range of transactions between plans and so called "parties in interest" to those plans, regardless of the fairness of the transaction (or whether it is on market terms). "Parties in interest" include the employer and/or union sponsoring the Plan and their affiliates, but also include any entity (and its affiliates) that provides services to a plan [5]. In particular, one of the prohibited transaction rules prohibits the provision of services to a plan by a party in interest to a plan. Therefore, the provision of services to a plan by any entity is generally prohibited unless an exemption applies.

To allow plans to access the services they need without violating ERISA, the statue has always contained what some refer to as the "Necessary Services Exemption" [6]. Under this exemption, the provision of services will not constitute a prohibited transaction if:

* the services are necessary for the …