BNA Pension and Benefits Blog

A Report on Yet Another Reporting Issue for Private Equity and Other Investment Funds

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.

Now the DOL is FAQuing It - Having Fun with "Funds" on the Form 5500

Issues relating to fees to service providers have become high-profile issues, with a proliferation of indirect-fee class actions and the inevitable follow-on press reports.  These issues have generated activity in four theaters: (i) the regulations under ERISA Section 408(b)(2), (ii) the rules governing Form 5500, Schedule C, (iii) the "404(c)" rules for covered plans with participant-directed investments, and (iv) a number of legislative proposals in Congress.  The DOL has moved forward in the first of these two arenas with proposed 408(b)(2) regulations and new rules for Form 5500, Schedule C, which have turned out to be flashpoints in the market for a firestorm of controversy affecting financial services organizations and plan sponsors alike.  Much (but not all) of the controversy has centered around the DOL's attempt to expand certain rules to a variety of types of indirect compensation and, apparently, in some cases, compensation for supposed indirect services, particularly in the context of fees surrounding "investment funds."

On July 14, the DOL issued FAQs intended to help with the administration and implementation of the new 5500 rules.  To its credit, using the efficient FAQ mechanic, the DOL is reacting quickly to a real need in the marketplace for guidance as to how these rules will work.  Putting aside the question as to whether everyone will agree with everything the DOL has done in the FAQs, it was critical that the DOL start to get on the record as to a range of seminal interpretive questions.  (And, thankfully, the FAQs were released almost a full week before the release of the The Dark Knight, so that I could read them without being distracted by what I'm anxiously hoping will be One of the Greatest Movies Ever Made.)

I'm writing here to take note of an arguably arcane but ultimately critical and interesting feature of the FAQs, relating to the nature of what is an "investment fund" for purposes of the new 5500 rules.  It did not go unnoticed by some that the new rules seemed to latch onto the concept of "investment funds" as a major underpinning of when the new indirect-type rules apply; however, the concept appeared to spring suddenly from within the authority, and didn't have a firm express basis is that which had come before.  (Yeah, it's a "lawyer point," I guess, in a group of FAQs with more direct practical implications, but, then again, I'm a lawyer.)  The issue was made more vexing by the fact that the new rules did not tap into the existing regime for look-throughs to investing plans, the so-called "plan asset" regulations (as modified by ERISA as recently amended), but rather went down this new, undefined "investment fund" road.

Thus, the scope of the "investment fund" concept, and by extension the very scope of a substantial portion of the new rules, became subject to something of a cloud right from the get-go.  For example, what is an "investment fund" anyway?  How do hybrid entities, like REOCs (real estate operating companies) and VCOCs (venture capital operating companies) under the "plan asset" regulations fit in?  How does the general "operating company" concept overlay on top of the fund analysis?  These questions, and the lack of any answers (or even discussion) regarding them, resulted in a significant analytical detour right out of the interpretive gate.

Well, Q&A 7 of the new FAQs is packed with a lot of information and goes a long way towards shedding light on how the DOL views these matters.  There is the description by example of what "investment fund" means, where the DOL says in a parenthetical: "e.g., mutual funds, collective investment funds."  (It may not seem like much, but it was more than we had.)  There is the posing of the basic question of whether compensation received in connection with the management of VCOCs, REOCs and other operating companies needs to be reported, and there is the DOL's pithy and straightforward (and, to me, clearly correct and appropriate) answer, "No."  There is the clarification that, notwithstanding the foregoing, fees or commissions received by a manager or adviser in connection with an investment in an operating company could be reportable.  And, underscoring the extent to which the DOL really seems to have created a whole new quasi-"plan asset" framework in the context of the reporting rules, the DOL states: "This answer would not be affected by whether the VCOC, REOC, or other operating company were wholly owned by a plan such that [under the "plan asset" regulations] the assets of the entity would be deemed to be plan assets."

This last nuance indicates that the formalistic approach under the bedrock "plan asset" rules falls, in the reporting context, to what may be a more intuitive analysis.  As a result, essentially all that matters here is whether there is an operating company present effectively to block the look-through, not whether the entity's assets technically are "plan assets." (The need to apply the technical rules to determine whether an entity is a VCOC or REOC (or other operating company) is still present.)  It remains to be seen whether this new conceptual approach will eventually be given application for other ERISA purposes.

The foregoing is just one small aspect of an important set of FAQs, and shows, even standing alone, how interesting the development of the reaction to the fees issue has been and probably will continue to be.  In this regard, note also that, in Q&A 40, the DOL states: "In an effort to address the concerns of both service providers and plans, the Department has decided that, with respect to those employee benefit plans which are dependent on service providers for information necessary to complete the Schedule C, the plan administrator will not be required for 2009 plan year reports to list a service provider on line 4 of the Schedule C [which basically calls for the listing of uncooperative service providers] as failing to provide information necessary to complete the Schedule C if the plan administrator receives from the service provider a statement that (i) the service provider made a good faith effort to make any necessary recordkeeping and information system changes in a timely fashion, and (ii) despite such efforts, the service provider was unable to complete the changes for the 2009 plan year."  Bravo - this relief (which presumably will spawn quite a lot of "statements") is extremely welcome in light of the fact that, as shown above, on even the most basic gateway issues there is a great deal of new concepts, analyses and information to digest.   

Local Option in Texas: The Great GASB

Any time a legislative body as large as that of the Texas House of Representatives passes a bill of greater import than the designation of a state flower (e.g., Yellow Rose) or nut (e.g., Pecan) by a unanimous vote (i.e., 140-0), you sense that something odd may be afoot.  As your blogger drafted, the New York Times last Friday (5/18) cast light on the recent passage of a bill in the Texas House that would reject GASB's rules governing disclosure of the cost of promised healthcare benefits for retired employees of the state and its political subdivisions.  (Mary Williams Walsh, "Auditing Rule Is Put at Risk by Texas Bill," NYT, 5/18/07, C1.)

Reportedly, the Texas Senate is expected to vote before Memorial Day on a "softened" version of the House bill which would permit the affected governmental units to adopt and apply the GASB rules but not require them to do so.

The Government Finance Officers Association (GFOA), which includes folks who manage and report on general-account public funds as well as benefit plans and other trust funds, have stirred up outright opposition to the adoption of the GASB rules on grounds which on their face seem Byzantine: the GFOA would rather have the public-sector entities adhere to the more stringent FASB rules which apply to the private sector but which, unlike the GASB rules, do not require "performance audits."

Whether the unanimity in the Texas House would have been breached in a compromise for a permissive-only approach to GASB, we cannot know.  One would think that at least a few votes, if not a majority, could be mustered against "local option," as in prohibiting or allowing the sale of alcohol.  However, if GFOA had its way, the FASB standards would be Texas's. Local finance officials would then have no choice but to bite the bullet on calculating and disclosing an actuarial cost estimate of their reporting units' accrued obligations to pay post-retirement healthcare benefits.

GASB or FASB, either would nevertheless greatly displease many local officials, such as the Travis County auditor, who oppose any rule which requires some calculation of the government's accrued obligations for "other [non-pension] post-employment benefits" (OPEBs).

To maintain, as the Travis County official has been quoted to say, that those obligations are "not measurable" because different actuaries at two different valuation dates previously furnished healthcare cost estimates as wide apart as $89 million and $320 million (although they later closely converged on numbers of similar magnitudes) is ostrich-like: it is not to deny that the significant millions involved are that much greater than zero.

In a practical world, there ought to be a way for that county government and others like it to be able to avoid or lessen the risk of having their current credit ratings promptly downgraded in the wake of disclosing astronomical numbers (in the context of their finances generally) with no funding plans in place. Public officials ought to be able to find midway courses between, on the one hand, drastic cuts in public services and employee payrolls and, on the other, huge hikes in any of those relatively few tax and other revenue sources that political subdivision units have control over.

In the immediate aftermath of the Enron era scandals, when most public pension funds had taken large hits to their funded status, the legislative tack taken in a number of states entailed the adoption of credible plans, instituting step-rate increases in employer contributions -- in some cases, accompanied by temporary, defeasible employee contribution increases.  These were calibrated to make funding progress while the equity markets regained public confidence and staged an expected comeback -- sooner or later. Those efforts are by now proving themselves effective.

Granted, trying to remedy a pension plan funding deficit is not as politically daunting a task as deciding to begin funding long-term benefit payouts from scratch.

Cities and counties which have not already begun that task could be -- and some are -- banking on a pipe dream: that someday very soon, through overarching Federal action, America will enjoy universal healthcare coverage.

But before new legislation can possibly be enacted and set on a path to implementation, which could occupy the entire term of the next adminstration, realistically Congress will have had to attack the long-term funding shortfalls under both Social Security and Medicare. The truly "universal" health coverage that many now yearn for will also need to address issues of co-existence with Medicare (including the Part D program instituted just last year) and, in time, the "universal" plan's transitioning into or possibly swallowing up at least the benefits side of present-day Medicare for Medicare eligibles.

Until then, state and local governments with retiree healthcare plans will be forced to fend for themselves in quandaries of their own making.  The present values of future benefit obligations created by plan sponsors have a reality of their own, an existence independent of rule-makers.

Abbott A. Leban

Closing the loop on Uncertain Tax Positions

Actions to Consider on Uncertain Tax Positions

So, if you have been reading all week, this posting will make sense.  If you have not read all week go down to the Tuesday post and read back through the week. Since many readers of this blog work within the benefits department of a company, are consultants or attorneys, they may not follow financial reporting standards that are not aimed specifically at compensation or benefit considerations. FASB Interpretation 48 is a general pronouncement regarding the need to measure, report and disclose uncertain tax positions. Public companies are already dealing with this.  But the standard applies to any income tax position and any enterprise – taxable or tax-exempt, that might owe income taxes. If a tax return position does not meet the more likely than not standard, the company must measure the potential impact on their tax liability and adjust their financial statements accordingly.  There is also additional financial statement disclosures required relative to this standard.  This standard applies to financial reporting periods beginning after December 15, 2006. Measurement and reporting applies to uncertain tax positions taken in any open tax year.

The good news is that the required disclosure is not specific by item. The bad news is that the auditor needs to examine each significant uncertain tax position and draw a conclusion regarding the certainty of success on that position. Auditor’s work papers are not subject to privilege. So the action point is to anticipate these issues and be prepared or help your clients get prepared to defend those tax positions that might otherwise be considered uncertain. If this work is done now, well in advance of when the auditor shows up, everyone is likely to be a lot more comfortable through the implementation of this new standard.

Another Accounting Standard Impact Benefit Plan Advisors

Benefit Plan Issues under FIN 48

We started this discussion in explaining that FIN 48 related to uncertainties in income taxes.  So the obvious question is:  Why worry about a tax-exempt benefit plan?

Well, the good news is, at least in my opinion; you generally will not need to worry about issues that would cause the plan to lose its exempt status.  FIN 48 includes a provision for recognized administrative systems that would permit the client’s tax position, even though it might otherwise appear uncertain. In my opinion (as far as it has developed to date), EPCRS should constitute such an administrative scheme. There is a recognized system to allow a plan to retain its exempt status in spite of potentially questionable practices, so it the majority of plans there should not need to be any estimate of a tax liability based upon qualification violations.

That doesn’t get benefit plans totally off the hook from analysis under this standard, however. Consider:

1. Funded welfare benefit plans:  Are the assumptions made about any reserve for incurred by not reported medical claims or post-retirement benefits reasonable or is an unrelated business income tax due?
2. Any funded benefit plan: 
   1. Is the trust invested in assets that could be considered to generate unrelated business income taxes?
   2. If the trust is invested in assets that trigger unrelated business income taxes, are there any material uncertain tax positions taken by such pass-through entities such as partnerships or trusts?
3. ESOPs of S corporations:
   1. Are the securities held by the ESOP qualifying employer securities? 
   2. Are the assumptions used in measuring synthetic equity for purposes of the broadly held test of IRC Section 409(p) reasonable?

Remember, if a plan has more than 100 (120) eligible participants, it is subject to audit.  Those plans are going to have to deal with this new standard, just like the plan sponsor. But, the measurement of materiality is generally lower for the benefit plan audit, than it is for the sponsor’s audit.  Thus, though these issues may be less frequently encountered in plans, when encountered they will likely be more significant.

Tomorrow we will talk about what this stuff really means to the client.

Continuing on FIN 48

Executive Compensation Considerations

This section highlights the frustration of any blog. This discussion is based on the prior discussion of new FASB Interpretation 48 – Accounting for Uncertainty in Income Taxes.  So, you need to read that section before you read this discussion. These postings are aimed at raising the awareness of the readers to compensation matters which may be considered “uncertain” under the new financial reporting rules and, as such, should trigger questions from the employer.

FIN 48 focuses attention on tax return positions. To sign a tax return, the position only needs a realistic possibility of success. That is a one in three standard.  FIN 48 requires more likely than not, which is something better than a 1 in 2 chance of success. This focuses a lot of attention on tax return positions that involve a degree of subjective decision making.  Those issues are very common when it comes to executive compensation.

1. IRC Section 162(m) generally limits the deduction of compensation for certain persons employed by a publicly traded enterprise to $1 million. That is an objective standard.  But there are many areas under Section 162(m) that are subject to judgment:
   1. Where equity compensation is included was the fair value actually determined at grant date? Was the determination of fair value reasonable?
   2. Has there been sufficient disclosure of the terms of the option plan?
   3. Can the performance pay exception be relied upon?
2. IRC Section 280G imposes very significant limits on the deduction of compensation triggered by a change in control. Like, 162(m), this includes objective and subjective criteria.
   1. Are amounts paid properly classified as reasonable compensation for services rendered following the change in control?
   2. Has base year compensation been measured properly?
   3. Has the exception for a small business corporation been properly applied?
3. Equity compensation takes many forms – options, restricted stock, phantom stock, stock appreciation rights and others.
   1. Was a transfer actually made?
   2. Was the date that the property was no longer subject to a substantial risk of forfeiture properly determined?
   3. Was the property valued correctly?
   4. Have any lapse or nonlapse restrictions been identified and considered?
4. Cash deferred compensation should be easy, but even here there are issues to consider.
   1. If services during the deferred period were rendered to multiple entities – who gets the deduction upon payment?
   2. Is it deferred compensation or a restricted property award? There are somewhat different deduction timing rules under Section 404 versus Section 83.
   3. When did “vesting” occur relative to payment? Is the payment truly deferred compensation?

Please do not assume that this is a comprehensive list. It would be nice if the readers would add other issues to this list to expand the idea of the kind of compensatory devices that are subject to evaluation under this standard.

Tomorrow, we will cover how the standard applies to benefit plans that are subject to a financial statement audit.