Typically, a hedge fund manager desires to include IRA investors in their fund. However, they are concerned, that in doing so, the manager and the funds assets may be subject to "Plan Asset" regulations and "Prohibited Transaction" excise tax. In considering this issue let's assume the following hypothetical facts:

  • that the hedge fund is a limited partnership conducting a private offering of its securities (limited partnership interests) pursuant to Section 4(2) of the Securities Act of 1933, Regulation D and 3(c)(1) of the Investment Company Act of 1940;
  • that pursuant to the agreement of limited partnership, the general partner of the limited partnership receives a performance allocation and the affiliated investment manager receives asset based compensation;
  • that the hedge fund invest solely in market listed securities, including listed option contracts, and that each of the funds is a party to a prime brokerage agreement with a registered broker-dealer pursuant to which the broker may extend credit to the funds or sell securities to the funds on a principal basis;
  • that a number of potential investors in the hedge funds are IRAs;
  • that the assets of the hedge funds do not include "plan assets" under a regulation (the "Plan Assets Regulation") issued by the U.S. Department of Labor ("DOL"), which is controlling both for purposes of the Employee Retirement Income Security Act of 1974, as amended ("ERISA") and section 4975 of the Code; and,
  • that for purposes of this analysis none of the investors in the hedge fund would be an employee benefit plan subject to ERISA.
The issue is whether the fund manager's acceptance of such IRA investments will cause the assets of the hedge funds to be considered to include "plan assets" and be subjected to the prohibited transaction excise tax.

Plan Assets and Prohibited Transactions

IRAs ordinarily are not subject to the fiduciary responsibility standards and prohibited transaction restrictions of ERISA. Transactions involving IRA assets, however, are subject to the prohibited transaction excise tax imposed by Section 4975 of the Code, which parallels the ERISA prohibited transaction restrictions. The prohibited transactions described in Code section 4975 include: any direct or indirect (i) sale exchange or leasing of property between a plan and a "disqualified person"1 with respect to the plan, (ii) extension of credit between a plan and a disqualified person, (iii) furnishing of goods, services and facilities between a plan and a disqualified person, and (iv) use of plan assets by or for the benefit of a disqualified person. In addition, these provisions prohibit any "fiduciary" with respect to a plan from dealing with plan assets in its own interest or for its own account.2 This restriction has been construed to prohibit a fiduciary from using its fiduciary authority in a way that results in the payment of an additional fee to the fiduciary itself or to a person in which the fiduciary has an "interest" that might affect the fiduciary’s best judgment as a fiduciary.3 Finally, section 4975 prohibits a fiduciary receiving any consideration for its own personal account from a party dealing with a plan in connection with a transaction involving the assets of the plan.4 The term "disqualified person" includes any fiduciary as well as any person providing services to a plan, together with certain affiliates of such a person.5 The term "fiduciary" includes any person who exercises any authority or control with respect to the management or disposition of plan assets. 6

The Plan Assets Regulation, as supplemented by section 3(42) of ERISA, describes how the fiduciary responsibility requirements of ERISA and the prohibited transaction excise tax provisions of section 4975 of the Code apply to private investment funds in which plans invest. In this connection, the Plan Assets Regulation establishes a "look through rule" under which a plan (including an IRA) is considered to own an undivided interest in each of the underlying assets of a private fund in which the plan invests, unless an exception applies. Thus, where the look through rule applies, transactions between the private fund and a disqualified person with respect to any IRA investor in the fund would be prohibited unless an exemption is applicable.

There are several exceptions to the look through rule established by the Plan Assts Regulation but the exception that is pertinent here relates to plan investments in private funds in which participation by "benefit plan investors" is not "significant."7 For these purposes, the term "benefit plan investor" includes plans subject to ERISA as well as plans (including IRAs) subject to section 4975 of the Code.8 Participation in a fund by benefit plan investors is "significant" if such investors in the aggregate own 25 percent or more of any class of equity securities issued by the private fund. For purposes of this computation, investments in the fund by the fund manager or any of its affiliates are disregarded.9

Prohibited Transaction Excise Tax

Section 4975 of the Code imposes an excise tax equal to 15% of the "amount involved" for each year (or part thereof) for which the prohibited transaction remains uncorrected. The excise tax is increased to 100% for each year (or part thereof) in which the prohibited transaction remains uncorrected after the earlier of (i) the date a notice of deficiency is mailed or (ii) the date the tax is assessed by the IRS.

Prohibited Transaction Exemptions

An investment manager of a hedge fund to which the look through rule of the Plan Assets Regulation applies must avoid prohibited transactions in order to avoid the application of the prohibited transaction excise tax discussed above. Because of the very broad definition of the term "disqualified person," it is often impossible to determine whether or not a transaction by a hedge fund involves a disqualified person with respect to one or more of the IRA investing in the fund.10 As a result, the only practical way to manage the hedge fund without incurring potential liability for the prohibited transaction excise tax is to rely on certain interpretive principles and exemptions.
These are discussed below.

Blind Market Transactions

With respect to fund investments in equity securities, the legislative history of ERISA and the Code indicates that an ordinary blind purchase or sale through an exchange, where neither the buyer nor seller (or agent of either) knows the identity of the other party involved, generally will not be a prohibited transaction.11 Such investments are not prohibited even if the security is issued by, or sold by, a disqualified person of the investing plan.

Principal Transactions Exemption

An administration exemption from the ERISA prohibited transaction restrictions, PTE 75-1, Part II, provides relief for transactions involving a purchase or sale of a corporate or government security between a plan and a disqualified person that is (i) a broker-dealer registered under the Securities Exchange Act of 1934, (ii) a government securities dealer reporting its positions daily to the Federal Reserve Bank of New York, or (iii) a bank,12 acting as principal, if certain conditions are met. These conditions are:

  1. In the case of a broker-dealer, it customarily purchases and sells securities for its own account in the ordinary course of its business as a broker-dealer.
  2. In the case of a reporting dealer or bank, it customarily purchases and sells government securities for its own account in the ordinary course of its business, and the purchase or sale with the plan is for government securities.
  3. The transaction is at least as favorable to the plan as an arm’s length transaction with an unrelated party and was not, at the time of the transaction, prohibited within the meaning of Code § 503(b). 13
  4. Except with respect to securities of SEC-registered mutual funds, the disqualified person is not a fiduciary with respect to the plan assets involved in the transaction. If the securities involved in the transaction are issued by a mutual fund, no fiduciary with respect to the plan who makes the decision on behalf of the plan to enter into the transaction can be a principal underwriter for, or affiliated with, the mutual fund issuing the securities involved.

Service Provider Exemption

ERISA section 408(b)(17) provides a very broad, and relatively simple, exemption that permits transactions between a plan assets entity and a person who is a disqualified person solely by reason of being a service provider (or an affiliate of a service provider) to the plan. "Service providers" of plans generally include financial institutions, such as banks, prime brokers, broker-dealers, investment advisers, insurance companies, or similar institutions. This exemption applies if (i) the service provider (or affiliate) is not a fiduciary with respect to the plan assets involved in the transaction, and (ii) the plan pays no more than, or receives no less than, "adequate consideration" in the transaction. If there is a generally recognized market for the asset, adequate consideration is based on the price of the security on a national securities exchange, or if the asset is not a security, the fair market value of the asset determined in good faith by a plan fiduciary. If the security is not traded on a national exchange, adequate consideration is a price not less favorable to the plan than the "offering" price established by the current bid and asked prices quoted by persons independent of the issuer and the counterparty, taking into account, in either case, the size of trade and marketability of security.

Incentive Compensation

The advisory fees payable by a private investment fund to which the look through rule of the Plan Assets Regulation applies can present issues under the fiduciary self dealing prohibition discussed above, to the extent the fund manager, who would be acting in a fiduciary capacity, is in a position to make portfolio investment decisions that would affect the amount or timing of those fees. In a series of advisory opinions, however, DOL has taken the position that a fee arrangement would not involve such prohibited self-dealing if (i) the investment portfolio to which the fees relate is valued based on market quotations or other pricing sources independent of the fiduciary, and (ii) fees based on unrealized gains also take into account unrealized losses. 14

Conclusion

Under the assumed facts the fund manager may manage a "plan assets" fund in which IRAs invest as benefit plan investors without being subjected to the prohibited transaction excise tax if it avoids prohibited transaction, engages in blind market transactions, or otherwise complies with an applicable exemption.


1 Code § 4975(c)(1)(A) - (D).

2 Code § 4975(c)(1)(E).

3 See Treas. Reg. §§ 54.4975-6(a)(5).

4 Code §4975(c)(1)(F).

5 Code § 4975(e)(2)(A), (B).

6 Code § 4975(e)(3).

7 29 C.F.R. § 2510.3-101(a)(2)(ii). See also ERISA § 3(42).

8 ERISA § 3(42).

9 Id.; 29 C.F.R. § 2510.3-101(f)(1).

10 For example, the custodian of an IRA is a disqualified person because it provides services to the IRA, and certain of the custodian’s affiliates are also disqualified persons by reason of the custodian’s provision of services. Therefore, any transaction between the fund and such disqualified persons would be prohibited (unless an exemption is applicable).

11 See H.R. Rep. 1280, 93rd Cong., 2d Sess., 307 (1974). Note that the blind market transaction exception generally applies to purchases and sales of equity securities on a market. Transactions involving debt securities are viewed as involving two separate transactions for purposes of the prohibited transaction restrictions: (i) the purchase or sale of the security itself, and (ii) the “extension of credit” that exists between the holder and the issuer of the security. The blind transaction exemption may cover the former, but another exemption may be necessary to cover the latter.

12 40 Fed. Reg. 50,845 (Oct. 31, 1975). For purposes of PTE 75-1, Part II, the term “broker-dealer,” “reporting dealer,” and “bank” includes such person and any affiliate of such person. An “affiliate” of a person for this purpose includes, among others, any person, directly or indirectly, through one or more intermediaries, controlling, controlled by, or under common control with such person.

13 Code § 503(b) applies to governmental plans within the meaning of Code § 414(d) and to church plans that have not make an election to be covered by ERISA.

14 See DOL Advisory Opinion 99-16A (Dec. 9, 1999); DOL Advisory Opinion 89-31A (Oct. 11, 1989); DOL Advisory Opinion 89-28A (Sept. 25, 1989); DOL Advisory Opinion 86-21A (Aug. 29, 1986); DOL Advisory Opinion 86-20A (Aug. 29, 1986).


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