The Pension Protection Act of 2006

September 7, 2006

On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (the “Act”).  While the Act contains comprehensive changes to the law governing employee benefit plans and pensions, this advisory focuses on provisions of the Act of particular interest to hedge funds and investment managers (i.e., changes to the “plan asset” rules and new prohibited transaction exemptions).

Changes to The “Plan Asset” Rules

Background

Pursuant to regulations promulgated by the Department of Labor (the “DOL”) under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), that have been partially amended by the Act, unless an exemption is available, if an entity engaged primarily in the investment of capital, such as a hedge fund, has “significant” participation by “benefit plan investors,” the plan’s assets will be deemed to include not only its equity interest in the hedge fund but also an undivided beneficial interest in each of the hedge fund’s assets, thereby subjecting the hedge fund itself to Title I of ERISA and Section 4975 of the Code.  In order to avoid this result, many hedge funds limit the participation of benefit plan investors in the fund to a level below the regulatory definition of “significant” (often called the “Significant Participation Test” or the “25% Test”).  ERISA regulations define “significant” participation in an investment entity as the condition where “immediately after the most recent acquisition of any equity interest in the entity, 25 percent or more of the value of any class of equity interests in the entity is held by benefit plan investors.” In part because the DOL deems the redemption of interests in a hedge fund as the acquisition of an interest by all non-redeeming investors, in order to satisfy the 25% Test, a hedge fund must at all times limit the investment of “benefit plan investors” in each class of equity in the hedge fund to less than 25% of the aggregated amount of such class of equity, excluding equity owned by the fund manager and its affiliates (the “25% Limit”). 

Before the enactment of the Act, the term “benefit plan investors” was defined to include (i) any employee benefit plan (as defined in section 3(3) of the Act), whether or not it is subject to the provisions of Title I of the Act, (ii) any plan described in Section 4975(e)(1) of the Internal Revenue Code, and (iii) any entity whose underlying assets include plan assets by reason of a plan’s investment in the entity. In addition, before enactment of the Act, if a fund of funds (“FOF”) or other entity that exceeded the 25% Limit participated in a second tier hedge fund or other investment vehicle, then 100% of the entity’s investment had to be counted as plan assets in measuring participation by benefit plan investors under the second tier fund’s 25% Test.

Change to Definition of “Benefit Plan Investor”

The Act revises the definition of “benefit plan investor” for purposes of calculations of the 25% Test to include only (i) employee benefit plans subject to Part 4 of Title I of ERISA, (e.g., private employer and union plans), (ii) plans subject to Section 4975 of the Code, (e.g., IRAs and Keogh plans) and (iii) entities whose underlying assets include plan assets by reason of a plan’s investment in such entity (i.e., entities that exceed the 25% threshold).  Thus, U.S. federal, state and local employee benefit plans, foreign benefit plans and church plans will no longer be considered benefit plan investors for the 25% Test and investments by these investors will not count against the 25% Limit on benefit plan investments.

Adoption of Pro-Rata Rule

Under the Act if an investment fund, such as a FOF, that exceeds the 25% Limit (and is, thus, deemed a “benefit plan investor”) invests in another fund, only the percentage of the FOF’s investment in the other fund that is attributable to the benefit plan investors’ ownership of the FOF, rather than 100% of the FOF’s investment, is counted toward the second fund’s 25% Limit.  For example, if benefit plan investors own 40% of a FOF, and the FOF makes a $20 million investment in a hedge fund, only $8 million of the $20 million FOF investment will count as plan assets for purposes of determining whether the 25% Limit is being exceeded by the hedge fund.

Additional Prohibited Transaction Exemptions

Background

Under ERISA and the Code, transactions between plans and “parties in interest” are prohibited.  The term “parties in interest” is defined very broadly as persons providing services to the plan or certain of the plan’s affiliates, including the employer or union sponsoring the plan, a plan’s fiduciaries and service providers to the plan.  The broad scope of this prohibition has made it difficult for plans to engage in certain routine financial transactions.  To alleviate this burden, the Act provides for several new exemptions from the party in interest transaction prohibition, which are described below.

Cross Trading

The Act permits cross trading (i.e., the purchase and sale of a security between a plan and another account managed by the same investment manager) if:

• The transaction is a purchase or sale for no consideration other than cash payment against prompt delivery for which market quotations are readily available;

• The transaction is effected at the independent current market price;

• No brokerage commission, fee (except a customary transfer fee as disclosed to the independent fiduciary authorizing the cross trading) or other remuneration is paid in connection with the transaction;

• An independent plan fiduciary for each plan participating in the transaction (other than the plan’s manager directing the trade or its affiliate) authorizes in advance and in writing the plan’s manager to engage in cross trading after the fiduciary receives a separate written disclosure regarding the investment manager’s cross trading policies and procedures; and

• Each plan participating in the transaction has assets of at least $100,000,000 (alternatively, if the assets of a plan participating in the transaction are invested in a master trust maintained by employers in the same control group, the master trust must have assets of at least $100,000,000).

In addition, for the exemption to apply, the investment manager directing the trade must:

• Provide a quarterly report to the plan fiduciary approving the cross trades detailing all cross trades in which the plan participated for that quarter;

• Not base its fee schedule or condition the provision of any other service (other than the investment opportunities and cost savings associated with cross trading) on the plan’s consent to cross trading;

• Adopt, and effect cross trades in accordance with, written cross trading policies and procedures that are fair and equitable to all accounts participating in the cross trading program and that include a description of the manager’s pricing policy and procedures and the policies and procedures for allocating cross trades, (the Department of Labor (“DOL”), after consultation with the SEC, will issue regulations that will specify the content of the policies and procedures required to be adopted by an investment manager within 180 days of the Act’s effective date); and

• Designate an individual who will be responsible to review compliance with the manager’s written cross trading policies and, following such review, to issue an annual report (signed under penalty of perjury) describing the steps performed during the course of the review, the level of compliance with the manager’s policies on cross trades and specific instances of non-compliance; the report must also notify the fiduciary of its right to terminate the plan’s participation in the cross trading program at any time. Note that it is the designee of the investment manager that must issue the annual report, not the investment manager.

Block Trading

The Act exempts from the prohibited transaction rules of ERISA and the Code transactions involving the purchase or sale of securities or other property (as determined by the DOL) between a plan and a party in interest (other than certain fiduciaries with respect to the plan) if:

• the transaction involves a block trade (i.e., any trade of at least 10,000 shares or with a market value of at least $200,000 which will be allocated across two or more unrelated client accounts of the investment manager directing the trade),

• at the time of the transaction, the interest of the plan (together with the interests of other plans maintained by the same plan sponsor) does not exceed 10% of the aggregate size of the block trade,

• the terms of the transaction, including the price, are at least as favorable to the plan as those of an arm’s length transaction, and

• the compensation associated with the purchase and sale is no greater than the compensation associated with an arm’s length transaction with an unrelated party.

Corrected Transactions

The Act exempts otherwise prohibited transactions in connection with the acquisition, holding, or disposition of any security or commodity if the party in interest reverses the transaction and restores to the plan or account any profits made through the use of plan assets within fourteen (14) days from the date the party in interest or a plan fiduciary discovers (or reasonably should have discovered) that the transaction was prohibited.  This exemption does not apply to any transaction involving the acquisition or sale of employer securities or employer real property or to any transaction in which, at the time that the transaction occurred, any plan fiduciary, the party in interest to the transaction or any other person knowingly participating in the transaction knew (or reasonably should have known) that the transaction would constitute a prohibited transaction.

Provision of Investment Advice to Plan Participants

The Act provides an exemption allowing advisers and other parties in interest to participant-directed account plans, such as 401(k) plans, to provide investment advice to plan participants.  The investment advice provided by the fiduciary advisor must be provided under an “eligible investment advice arrangement” and must satisfy other requirements, including appropriate disclosure of the investment advice.  An “eligible investment advice arrangement” is an arrangement that either: (i) provides that fees (including any commission or other compensation) for the investment advice do not vary depending on the basis of any investment option selected or (ii) uses a computer model under an “investment advice program” (as defined in the Act).  Records of the advice must be maintained for six years.  This exemption will be effective for transactions occurring after December 31, 2006. 

Other Exemptions

In addition to the exemption described above, the Act provides other new exemptions with less relevance for hedge funds and independent investment managers.  These include exemptions for (i) certain foreign exchange transactions between a bank or broker dealer (or an affiliate of either) and a plan where the bank or broker dealer (or affiliate) is a trustee, custodian, fiduciary, or other party in interest, (ii) certain transactions involving the purchase and sale of securities (or other property determined by the DOL) between a plan and a party in interest executed through an electronic communication network, alternative trading system or similar execution system or trading venue subject to regulation and oversight by an applicable federal regulating entity, and (iii) transactions between a plan and a non-fiduciary service provider (or its affiliates) involving the sale, exchange or leasing of property, extension of credit or transfers or uses of plan assets to or by such service provider or its affiliate, where the plan receives no less or pays no more than adequate consideration.

In addition, the Act provides that ERISA fund managers and advisers who are also registered brokers or dealers subject to the fidelity bond requirements of a self-regulatory organization will no longer need to be covered by an ERISA bond, effective for post-2006 plan years.

For additional information on this topic, you may contact Howard A. Neuman and Carol Spawn Desmond.