Pension Protection Act of 2006 Modifies ERISA's 25% Plan Asset Exemption

The President signed the Pension Protection Act of 2006 (the "Pension Protection Act") into law on August 17, 2006.  The Pension Protection Act amends many of the provisions of the Employee Retirement Income Security Act of 1974, as amended ("ERISA").  As discussed below and of particular significance to private investment funds, the Pension Protection Act (among numerous other changes) amends certain provisions under the "plan asset regulations" issued by the U.S. Department of Labor.

A. Background and Prior Law

In 1986, the U.S. Department of Labor issued regulations (the "Plan Asset Regulations") addressing whether the assets of a plan (an "ERISA Plan") subject to Title I of ERISA or Section 4975 of the Internal Revenue Code, as amended (the "Code"), will be deemed to include an interest in the underlying assets of an entity (for example, a private investment fund) if an ERISA Plan acquires an "equity interest" in such entity.  In other words, the Plan Asset Regulations address whether the assets of an entity, such as a private investment fund (a "Fund"), will be considered "plan assets" of the investing ERISA Plans.  If the assets held by a Fund are deemed to be "plan assets," the fiduciary responsibility and prohibited transaction rules of ERISA and the Code will apply to the Fund.  If it wishes to avoid having its assets deemed "plan assets," a Fund typically employs one of the following three strategies: (i) structure the Fund to qualify as a venture capital operating company ("VCOC"), (ii) structure the Fund to qualify as a real estate operating company ("REOC"), or (iii) limit investment by ERISA Plans (and other investors that are "benefit plan investors") in the Fund to less than 25% of the value of each class of equity interests in the Fund (the "25% Test").  Under prior law, "benefit plan investors" was broadly defined to include not only ERISA Plans and IRAs, but also governmental (e.g., public pension), foreign, church and other employee benefit plans that are not subject to ERISA. 

B.Pension Protection Act

Although the Pension Protection Act retains the 25% Test, the definition of "benefit plan investor" has been revised to include only plans that are subject to Title I of ERISA and/or subject to Section 4975 of the Code (e.g., IRAs).  The Pension Protection Act has the effect of excluding, for example, foreign, governmental and most church plans for purposes of the 25% Test. 

The Pension Protection Act also provides a proportionate look-through rule for applying the 25% Test to a Fund whose investors include an entity holding plan assets.  Under this rule, a Fund investing in another fund will be considered a "benefit plan investor" for purposes of the second fund's 25% Test only to the extent of the equity interests held by "benefit plan investors" in such Fund.  For example, if 50% of the interests in a fund of funds are held by ERISA investors, then when that fund of funds invests in a Fund, only 50% of the fund of funds' investment in such Fund will count as an investment by a "benefit plan investor" under the 25% Test.  Under the prior law, the fund of funds' entire investment would have been counted as an investment by a "benefit plan investor" for purposes of the Fund's application of the 25% Test.

C. Impact on Existing Funds

Depending on a Fund's investor base and its governing and other operative documents (e.g., side letters), the revised 25% Test may offer more flexibility to a Fund.  For example:

• A Fund relying on the 25% exemption may have additional capacity to accept more benefit plan investors into the Fund and still be able to satisfy the 25% Test.
• A Fund that relies on the VCOC or REOC exemptions because it does not satisfy the 25% Test under the prior law may satisfy the revised 25% Test under the Pension Protection Act.  Since the VCOC and REOC exemptions impose significant restrictions on the manner in which investments are made by a Fund as well as stringent ongoing compliance obligations, the revised 25% Test could provide a Fund more flexibility in making investments.

It is important to note that even the revised 25% Test has its own compliance concerns as the test must be applied to each equity class any time there is a change in ownership percentage for any class of equity interests in a Fund (such as an acquisition, disposition or transfer of interests in the Fund).  Further, where a fund of funds that has ERISA investors invests in a Fund, the Fund has to make sure that the percentage ownership of the ERISA investors in the fund of funds has not changed.

A Fund that intends to take advantage of the benefits offered by the Pension Protection Act will also need to review their investor disclosures and governing documents to determine whether changing from the VCOC or REOC exemptions to the 25% Test is permissible.  If a Fund has committed to operate as a VCOC or REOC, but now can satisfy the 25% Test as revised under the Pension Protection Act, an evaluation should be done to see if the Fund can amend its governing and other operative documents and whether limited partner consent would be necessary for such amendment.   In addition, before relying on the revised 25% Test, Funds should also determine whether any governmental or non-US pension plan investors have imposed contractual obligations on the Fund to treat it as a plan subject to ERISA.   Finally, if a Fund abandons VCOC or REOC compliance for the new 25% Test, it is important to remember that it may not be able to regain it should that become necessary at some later time (VCOC or REOC management rights must be regularly exercised from the first investment).

In summary, the Pension Protection Act may provide Funds with the opportunity to accept significantly more capital from certain investors in the future and additional flexibility in making investments.  If you have any questions about the information contained in this Client Alert, please contact Keith Kaplan (215-569-4143), Jon Katona (215-569-4222) or Mark Beaver (215-569-4769).

This information has been prepared by Klehr, Harrison, Harvey, Branzburg & Ellers LLP ("Klehr-Harrison") for general information purposes only.  It does not constitute legal advice, and is presented without representation or warranty as to its accuracy, completeness or timeliness.  Transmission or receipt of this information does not create an attorney-client relationship with Klehr-Harrison.  Parties seeking advice should consult with legal counsel familiar with the particular circumstances.