BNA Pension and Benefits Blog

Section 404(a)(1) of ERISA generally requires a fiduciary to act in the interest of participants and beneficiaries and to act prudently. ERISA also requires, under Section 103(b)(3)(A), an annual report which includes a financial statement containing, among other things, a statement of assets and liabilities "valued at their current value." Current value is to be determined in good faith by a trustee or named fiduciary.

A July 1, 2008, letter from James Benages of the DOL's Boston office has made its way around the market. There, he considers a plan which was invested in a number of alternative investments ("AIs" (no relationship to the Kubrick/Spielberg movie, at least I don't think so)), and which apparently took a fairly common approach to the Form 5500 reporting thereof. For example, one particular AI was valued at cost by the applicable committee "based on the general partner's unaudited Capital Account Balance Statement" for the period in question "and the accompanying audited financial statements." Another was valued according to the general partner's unaudited determination of fair market value.

The July 1 letter states that (i) not only has the committee "failed to establish a process to determine the most accurate fair market value," but cost and fair market value have been "equate[d]," (ii) such failure violates ERISA's "solely in the interest" requirement, and (iii) as a result, in the DOL's view, the committee "is in violation of ERISA and will remain so until it takes corrective action." Before discussing Section 502(l) and the possibility of action by other governmental agencies and third parties, the July 1 letter kindly comforts that, if corrective action is taken, no lawsuit will be brought by the DOL.

The issues implicated by the July 1 letter are significant. Many private equity and other investment funds provide valuations on the bases noted in the letter, and plan fiduciaries would not ordinarily be expected to have the information required to second-guess the available valuations or the expertise to do so even if they had the information.

The DOL's approach seems to raise the specter that making an investment not practically susceptible to ready valuation is somehow a per se violation of Section 404(a)(1) of ERISA. The July 1 letter seems expressly to tie the "sole purpose" requirement to the reporting requirement, although the connection isn't particularly clear. There's also a more oblique reference to the Section 404(a)(1)((B) prudence requirement, not tied specifically to the reporting issue. Is the DOL implying that it is per se imprudent for a fiduciary to invest in a difficult-to-value investment, without special valuation efforts?

What would be the effect of there being a Section 404(a)(1) violation merely because an investment is not subject to valuation? Several alternatives seem possible.

Maybe the plan would demand that the fund provide appraised valuations. A number of funds, however, would presumably not be anxious to engage an appraiser, whether because of an unwillingness to develop and distribute the valuation, an unwillingness to spend the time and money on the valuation or an unwillingness to share the underlying information with the appraiser.

Maybe the plan would do its own analysis. However, any number of plans presumably would not have the time or inclination to do so.

Maybe the plan would ask for additional factual information to facilitate the plan's valuation efforts. It is by no means clear that the fund would provide such information.

Or maybe the plan would simply decide it's not worth the effort. To someone who does not appreciate AIs, maybe this result is somehow acceptable.

But is it? It is not up to non-experts to decide that a class of investments is suboptimal, whether or not there are experts out there who might agree. Clearly, AIs have enthusiastic support as a part of an overall portfolio from a wide range of investment professionals, and it is up to the responsible fiduciary to make the actual investment decision. The fact that support is not unanimous is a fact to be taken into account by the responsible fiduciary.

I recognize that there are those who will disagree, even vehemently. (I'm ducking already.)  Some have made the argument that there is no possible way that an unvalued/unvaluable investment can be prudent. I would point out that almost by definition such a conclusion has been rejected as a business matter by substantial portions of the market - the investments are in fact being made, often by the most sophisticated of investment professionals. (If Warren Buffett were to offer me the opportunity to invest in a black box of managed investments for a 10-year term with no information and a de minimis fee, would I be imprudent to make the investment? Maybe I'd be imprudent not to do so.)

To me, one of the areas (the only one?!) in which ERISA has consistently been lauded is its use of modern portfolio theory and deference to the expert fiduciaries regarding portfolio choices. Notwithstanding the apparent trend of some in the government to pretend that they are competent to decide what plans can invest in, as evidenced by the recent and possibly continuing commodities-legislation debacle, ERISA arguably has no legitimate role in trying to identify specified types of investments as imprudent per se. ERISA should not be responsible for depriving the most sophisticated managers from being unable to access, on behalf of ERISA plans, the most sophisticated investments.

A potential gut reaction is that this whole issue is a tempest in a teapot - if plans are made unable to invest in AIs in the absence of developed valuation information, the funds will naturally come up with improved information. However, the dust-up of several years ago where governmental investment put funds' confidentiality at risk, resulting in an unwillingness of some funds to accept government-plan investment, shows that there could come a point at which funds will indeed turn their back on money over regulatory issues. Further, even if the market would adjust, there is a question of whether it should have to adjust.

To me, the first step is to limit the analysis to where it belongs. The level of valuation information to be given over time by a fund should be considered another factor, not some super-factor, taken into account by a court in analyzing whether, on all facts and circumstances, the fiduciary has satisfied its Section 404(a)(1) obligations. It is suggested here that the lack of a draconian penalty for violating Part 1 requirements doesn't mean that those violations are somehow magically converted into Part 4 violations (any more so than would be in the case of, for example, a failure to distribute an SPD).

That still leaves Section 103(b)(3)(A), which applies on its face to require fair-value reporting. The reporting obligations help get information out to participants and beneficiaries, and bear upon the plan's funded status. In this latter regard, if the valuation information is inaccurate, the entire funding regime is potentially compromised. If I invest in a company with $100 million in reported assets, and the company assets are "really" only worth $1 million, my investment may well not be all I thought it was.  A plan's funded status could be similarly misrepresented. 

One possible interesting solution would be to focus on the practicalities of the situation (thanks to Andrew Gaines for talking this through with me). As a practical matter, AIs are likely to constitute only a small percentage of a plan's total portfolio, being there to provide a potential large maximum return as to a portion of the portfolio deemed suitable by the experts for investment at higher risks. If a concern is that overreporting of asset value could somehow place a plan at risk (or, in the case of underreporting, give rise to excessive deductible plan contributions), maybe an answer could be to allow reasonable reporting based on information disseminated in accordance with market practice (e.g., historical cost or GP estimates), but only as to a portion of the plan's portfolio not to exceed certain percentages. Presumably, given the role of AIs in most portfolios, this percentage could be made fairly low without excessive market dislocation.

AIs can form a critical part of a plan's investment strategy, and in some cases probably account in part for superior overall performance. The point here is not to argue that AIs are or are not smart investments; rather the point is to argue that the question of investment choice is for the investment professional, and that it would be unfortunate if the reporting rules were to serve as an impediment to the making of an otherwise permissible investment at the direction of a responsible plan fiduciary.

O.k.  so I am a sucker for B science fiction movies.  If we are going to continue these postings on accounting issues, I just wanted to get your attention.

This posting is on a slightly different tack than those I posted last year.  This falls more into the category of client service.  Regular tax season is coming to a close and the season for auditors to turn to benefit plan audit work is nearly upon us.  That made me think of some of the problems we encountered last year and the fact that advance knowledge and enlisting the assistance of the legal community might be helpful.

As you know, ERISA Section 103(a)(3)(A) requires certain plans to attach audited financial statements to their annual filing.  The statute specifically provides that such statements shall be prepared in accordance with generally accepted accounting principles (GAAP) and the audit must be conducted in accordance with generally accepted auditing standards (GAAS). 

In recent years both of those requirements have caused a fair amount of stress in completing these engagements.  The EBSA office of the Chief Accountant takes these requirements very seriously.  They have conducted two audits of the auditors over the last decade with less than favorable findings.  They have reported auditors to the AICPA and their state licensing boards and reprimands have been issued.  However, this has not resulted in the increase in the level of (dare I say) accountability, that the government would like to see.  Thus, they have announced at various forums that they are going to start holding the sponsor responsible for the quality of the audit and assessing a $50,000 penalty for each report that is filed with a less than acceptable audit.

So - what is an acceptable audit?  The AICPA Audit and Accounting Guide - Employee Benefit Plans includes the fundamental GAAP and GAAS standards for benefit plan audits.  A few of those requirements are particularly invasive and frequently involve legal counsel, so that is what I wanted to address in this posting.

1.  Related party transactions:  GAAS requires that the auditor look at all related party transactions with an eye to potential prohibited transactions.  This means things like the auditor having to get some kind of comfort that employee salary deferrals or loan payments have been deposited on a timely basis.  Some auditor's will take the 15th business day of the following month as if it is a safe harbor, others will not.  In any event, it is a required audit step and not just something that comes up as the part of random systems tests.  So, plan sponsors are best served if they have already documented their procedures to demonstrate that they current process meets the regulation.

2.  Asset values:  Whether it is the prohibited transaction rules where the auditor has to test related party sales or purchases for "adequate consideration" or the value of non-traded assets for simple financial statement reporting, GAAS requires that the auditor takes specific steps with respect to any valuation product.  Whether it is an internal valuation estimate or an independent outside appraisal, GAAS requires the auditor to look not simply at the credentials of the person performing the valuation, but also at the data provided to them to make the determination and the reasonableness of the assumptions employed.  See SAS 101 - Auditing Fair Value Measurements and Disclosures.  Recently, legal advisers to ERISA fiduciaries have advised them to refuse to provide a copy of the valuation report to the auditor.  That leaves the auditor in a bind.  They either have to figure out some way to get the report, see if they can replicate the results of the report or issue an opinion that includes a "scope limitation."  Under current EBSA procedures any report that receives such a scope limitation is reviewed by a real person prior to acceptance.

3.  HIPAA matters:  When auditing a health plan, GAAS requires the auditor to do some claims testing.  This means access to confidential health information.  Auditors are accustomed to dealing with this kind of confidential information and their access to the information should be considered administratively necessary.  Nevertheless it is frequently a hard fought and costly battle to get all of the parties to agree to the terms required to let the auditor access the information.  Front end recognition of this requirement and planning for it to happen can speed the completion of these audits.

4.  Other confidentiality matters:  This arises most frequently on health plan audits.  Frequently a claims administrator concludes that they have some kind of proprietary rights to systems, pricing arrangements, etc.  They either refuse to provide access to the information or attempt to place limitations on the audit, such as pre-approval of the auditor's report, pre-approval of allowable audit procedures, etc. These actions are not consistent with an audit conducted in accordance with GAAS.  Thus, once again, the sponsor is faced with having to intervene to obtain access to the appropriate data or have the auditor issue a scope limitation on the audit report with the resulting extra scrutiny.

I suspect that there are other areas where advance planning is required.  These are just a few of the areas to give you an idea of what the audit faces in trying to do a good job for the plan administrator.  So, spend a little time with your auditor planning the engagement, anticipating these issues.  It really will help in the long run.