IRAs do not Cause (but do Exacerbate) Plan Asset Problems under ERISA

The Employee Retirement Income Security Act of 1974 (ERISA) is a complex mega-statute administered by the U.S. Department of Labor (DOL) that regulates employee benefit plans. Hedge funds generally need to avoid being subject to ERISA, as the regulations are cumbersome and impose numerous restrictions, many of which cannot be met without the hedge fund manager qualifying as an ERISA fiduciary.  This, in turn, requires that the fund manager be registered as an investment adviser with the SEC, which, in turn, requires that the fund manager have in excess of $100 million under management.  This obviously is not realistic for most hedge fund managers who are just starting out.

To avoid falling under ERISA, hedge funds need to make sure that ownership of the fund by benefit plan investors is not significant, which is set at 25% or more of the fund’s ownership by DOL in 29 CFR 2510.3-101(f). That regulation defines benefit plan investors to include any employee benefit plan as defined by ERISA in Section 3 (29 USC § 1003) as well as any plan described in Section 4975(e)(1) of the Internal Revenue Code. (The IRC is another complex mega-statute, which ERISA borrows from liberally, making it all the more fiendish to work with.)  The referenced IRC provision problematically draws in IRAs as one of the types of plans to worry about.

This is about when my phone rings and a client says that he’s been doing some reading and it appears he is not allowed to take any IRA money, or at least no more than 25% of the investors’ funds can be from IRAs.

Part of the problem here is just the unintended consequences of the ubiquitous internet, which allows anyone to read anything, whether in or out of context.  Here the plan asset regulations are being read out of context.  Regulations are triggered by statutes.  You don’t need to read regulations on employee safety, for example, if you don’t have any employees.  But if you do start reading them, you probably will find numerous potential violations.  DOL is part of the executive branch of the federal government, and it can only regulate where Congress has delegated authority to DOL to do so.  That authority is found in ERISA, and Section 3 of that statute says that ERISA’s coverage includes employee benefit plans established or maintained by any employer or any employee organization (such as an union).  It doesn’t say anything about hedge funds. In the absence of a statutory trigger, the DOL's plan asset regulations can't drag you into ERISA.

As a practical matter this means that if you’re setting up a hedge fund, and one of your clients is a pension fund, you need to pay attention to ERISA.  In that case, you also need to count IRAs towards the 25% threshold.  However, if none of your investors are pension funds, then (as far as ERISA is concerned) you ought to be able to take as much IRA money as your individual clients want to invest, whether that makes up 25% or more of the total investments in your fund.

But we can't forget the IRC.  In a future post, I plan to discuss Section 4975, which imposes a tax on prohibited transactions that is triggered by plan assets.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.