Pooling Investors' Assets

Art by Tim BowerPooling investor assets results in a number of efficiencies including significant cost savings. That said, advisers should be aware of certain considerations that arise depending on the types of investors that participate in pooled investment funds. Specifically, certain requirements under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) must be met when accepting benefit plan investors, such as ERISA-covered plans and individual retirement accounts (IRAs).

If the assets of the pool are plan assets and at least one ERISA-covered investor is invested, the adviser and other parties connected to the pool will be subject to ERISA’s fiduciary duty provisions and the IRC’s prohibited transaction provisions. Further, if IRAs invest in the pool, the IRC’s prohibited transaction (PT) provisions will apply.

Advisers should be familiar with authorities that provide guidelines on the nuances of the “plan assets” status. Department of Labor (DOL) Regulation Section 2510.3-101 and ERISA Section 3(42) establish when the assets of a pool are deemed plan assets. The intent behind the DOL regulation, issued in 1986, was to prevent parties from avoiding fiduciary status by simply pooling the assets of investors. Section 3(42) was enacted by Congress in 2006 to make some of the regulation’s requirements easier to apply and to reduce the instances in which the assets of an entity are deemed plan assets.

The assets of an entity that issues “publicly offered securities” as defined in the regulation and the assets of an investment company registered under the Investment Company Act of 1940—e.g., a mutual fund—are not plan assets for purposes of ERISA and the IRC. On the other hand, some assets are always plan assets with regard to ERISA-covered and IRA investors: the assets of a group trust that is exempt from tax under IRC Section 501(a)—also known as an 81-100 trust; a common or collective trust fund of a bank; and a separate account of an insurance company—i.e., other than a separate account maintained solely in connection with fixed contractual obligations of the insurance company if certain conditions are met. A portion of the assets of an insurance company general account may also be plan assets.

The regulation further provides that the assets of an operating company, which include a real estate operating company (REOC) and a venture capital operating company (VCOC), are not plan assets. An operating company is an entity “primarily engaged, directly or through a majority-owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.” The REOC and VCOC are types of operating companies specifically defined in the regulation. REOCs are entities that primarily invest in and manage real estate, while VCOCs invest in operating companies or REOCs—though not other VCOCs—and play a role in managing investment operations.

Finally, the assets of an entity are deemed plan assets if participation of benefit plan investors in any class of equity issued by that entity is significant. Ownership is considered significant if more than 25% of the class is owned by such investors. Section 3(42) of ERISA modified the application of this “significant participation” test in the regulation. A benefit plan investor is, for the most part, an ERISA-covered plan, an IRA or another entity whose assets are deemed plan assets.

The determination of whether the assets of a pool are plan assets is important. If they are not plan assets, an adviser and other parties will not be acting as fiduciaries with regard to management and other activities connected to the pool.

If a pool holds plan assets, the adviser and possibly other parties will be fiduciaries. Fortunately, there are common prohibited transaction exemptions (PTEs) available to advisers managing plan assets. For example, advisers commonly rely on the qualified professional asset manager (QPAM) exemption. Importantly, this exemption is available only to certain advisers, such as banks, insurance companies, broker/dealers (B/Ds) and registered investment advisers (RIAs) that meet certain minimum size requirements. Thus, smaller adviser firms may not qualify for the exemption. An exemption strategy may also be dictated by the type of pool. For example, a specific exemption is available to bank-maintained collective investment trusts (CITs).

In summary, while ERISA-covered plans, entities whose assets are plan assets, and IRAs may be attractive sources of investment capital for a pool, advisers should be aware of the implications of holding plan assets, and structure their operations either to avoid managing such assets or to have an appropriate compliance apparatus in place to ensure adherence to ERISA and the IRC.

David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers. He served on the Department of Labor’s ERISA Advisory Council from 2012 through 2014.