Background
Much of the available investment capital available globally is held by pension plans, and much of the plan capital comes from employee benefit plans subject to the Employee Retirement Income Security Act of 1974 (ERISA). ERISA comprehensively regulates the conduct of fiduciaries of ERISA plans (i.e., generally, private U.S. employee benefit plans).
One issue that arises under ERISA is whether the assets of an entity that accepts equity investment from a plan are, by virtue of that investment, considered "plan assets" subject to ERISA. A great many entities, including a large number of securitization vehicles, need to avoid ERISA's comprehensive rules and thus to avoid characterization as a plan-asset entity. One exception to treatment as plan assets applies when less than 25% of each class of equity (or quasi-equity) of an entity is held by "benefit plan investors." "Benefit plan investors" had been broadly defined for these purposes to include all employee benefit plans and individual retirement accounts whether or not subject to ERISA (not taking into account interests held by certain parties with influence over the investment of the entity).
In addition, ERISA broadly prohibits transactions between plans and certain related parties. Thus, whether or not an entity's assets are plan assets, ERISA will be relevant to the operation of the entity. If a prohibited transaction does occur, there could be material taxes and other penalties on the non-plan party to the transaction (i.e., the party related to the plan), and a risk that the transaction might have to be rescinded. These rules have caused those structuring transactions and proposing to enter into transactions to be wary of the ERISA rules and to take them into account when documenting, disclosing and negotiating the transaction.
Responding to outcry regarding the manner in which ERISA was affecting U.S. investment markets and even the global marketplace, Congress in the Pension Protection Act of 2006 (the "Act") modified ERISA in several critical ways, as discussed below. The new law will have a significant impact on securitizations.
Discussion
Equity interests and the 25% test
As indicated above, regarding equity (including quasi-equity), the rule under the 25% test noted above had been that non-ERISA plans, including governmental plans and non-U.S. plans, were taken into account as benefit plan investors, thus constraining purchases by ERISA plans and non-ERISA plans alike. (An express purpose of the test was to attempt to identify situations in which there is a substantial expectation that an entity's assets would be managed in furtherance of the investment objectives of plan investors, and the definition of benefit plan investor was therefore not restricted to ERISA plans.) One possible approach in the market to dealing with this issue was to prohibit purchases by ERISA plans altogether; in that event ERISA would not apply at all, vitiating the need to limit investment from non-ERISA plans. (It is noted that there could have been some relevance to the 25% test even for a vehicle not accepting any ERISA investment, if the vehicle would be investing in an entity itself using the 25% test to limit plan investment in the entity.)
A number of practical issues had arisen in the market in connection with equity purchases, including the following:
*With so much of global investment capital coming from employee benefit plans, it was becoming difficult in many cases to market transactions within the 25% limitation, especially because the decision to allow any ERISA investment whatsoever resulted in subjecting non-ERISA plans to the limitation.
*Issues arose with the monitoring of the 25% test, particularly in non-U.S. markets, which are frequently paperless electronic markets. While some took the position that deemed assurances that a purchaser was not a plan (whether or not subject to ERISA) were sufficient, others were more concerned about the reliability of deemed assurances depending on the surrounding facts and circumstances. Varying levels of comfort on these points were found in the marketplace, resulting in uncertainty and variation within the market, and on potential drags on marketability depending on the approach taken.
*Some in the market took the position that dual entities could be established, where one would bar ERISA plans from investing and the other would satisfy the 25% test. Under that approach, the position was that neither entity would be subject to ERISA. Others were less comfortable with this approach depending on the situation, again creating uncertainty and variation within the market. There were also questions regarding whether funds in which non-ERISA plans invested over the 25% threshold, but in which there were no ERISA investors, should be viewed as benefit plan investors at all.
The Act dramatically affects the analysis, as follows:
*Non-ERISA plans are no longer considered benefit plan investors, and the 25% test will now operate as a true de minimis rule, more simply testing whether ERISA plans, rather than all plans in the aggregate, exceed the 25% limitation. (For these purposes, as before, IRAs are effectively treated in the same manner as ERISA plans.) Thus, non-ERISA plans are now grouped with other non-plan investors in the calculation under the 25% test, and investment by governmental, non-U.S. and other non-ERISA plans may (with respect to ERISA concerns) be accepted without limitation. Indeed, whereas before the acceptance of investment by non-ERISA plans served to constrain the ability of an entity to accept investment by plans, now investment by non-ERISA plans will serve to make more room for investment by ERISA plans (i.e., by increasing the denominator under the 25% test, without increasing the numerator).
*Issuers and other parties that were concerned regarding the acceptance of deemed assurances may want to review whether they have increased comfort with deemed rather than actual assurances, as it is possible that the new rules may provide additional bases for the acceptance of deemed assurances.
*The issue of whether or not a fund in which no ERISA plans invest can ever be a benefit plan investor has largely been mooted, as non-ERISA plans are no longer benefit plan investors and therefore cannot cause the funds in which they invest to be benefit plan investors (indeed, as noted, their investment in a fund would help, not hurt, the fund's ability to pass the 25% test).
Under another potentially cumbersome aspect of the 25% test, before the Act there was the risk that a plan-asset fund investing in another downstream entity would in effect be considered to be 100% plan assets for purposes of that entity's 25% inquiry. Under the new law, an entity will be deemed to hold plan assets only to the extent of the percentage of the equity interests in the entity held by benefit plan investors. This change presumably makes it easier for securitization vehicles using the 25% test to accept investments from a fund-of-funds, which is only partially, but not entirely, comprised of ERISA assets.
It is noted that a number of single-asset or other fixed-asset or similar securitizations are done on the basis that the securitization vehicle, which would involve limited or no discretionary activity at the vehicle level, could be structured to satisfy ERISA concerns even if its assets are considered plan assets. In those cases, the above considerations would not generally be applicable (although the considerations below might be).
Debt and prohibited transactions
Regarding purchases of debt (as opposed to equity or quasi-equity), practitioners frequently were concerned with the breadth of ERISA's prohibited transaction rules, which potentially apply to prohibit transactions, no matter how fair and reasonable, between plans and certain related parties ("parties in interest" and "disqualified persons"). For these purposes, a mere service provider to a plan is considered related.
A number of practical issues had arisen in the market in connection with debt purchases, including the following:
*Particularly in light of the consolidation in the financial services industry, and the risk that any given financial institution may be or become a service provider to any given plan, this related-party prohibition effectively became what might be viewed as a general rule - rendering plans and their counterparties unwilling to proceed with transactions generally in the absence of a statutory, class or individual exemption. It is not uncommon for financial institutions to require a potential counterparty to provide assurances that is not and would not be a plan subject to ERISA, or that an exemption (e.g., the so-called QPAM exemption) applies.
*Offering documentation commonly contains fairly lengthy descriptions of ERISA considerations applicable to debt purchases (many of which, in addition to the considerations relating to the 25% test discussed above, are similarly applicable to equity purchases).
The analysis here is again affected by the Act, as follows:
*The Act generally provides that many transactions between a plan and a party in interest acting as a mere service provider - and which is not a fiduciary with respect to the assets involved in the transaction - will be allowed if the transaction is for "adequate consideration" (as defined for these purposes). Thus, it appears now generally to be the case that transactions with mere service providers may, in a number of cases, steer clear of the ERISA thicket if not off-market, thus eliminating in such cases the risk of what may be viewed as an accidental prohibited transaction just because the non-plan counterparty happened somehow to be a service provider to the plan somewhere around the globe. (It is noted, however, that a number of interpretive and practical issues may arise under the "adequate consideration" definition under the Act.) The Act also now provides for additional relief in the form of a 14-day correction period for certain inadvertent prohibited transactions involving securities and commodities.
*Institutions may want to re-examine whether the level of concern they have over these issues in the case of debt purchases is as high as before, and whether they may henceforth be able to seek more user-friendly assurances from plans and potential plans. They may also wish to review whether the ERISA disclosure they have been incorporating into their offering documents may be able to be more streamlined.
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