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Sept 1992

Trusts as active investors. (The CPA in Industry)

by Vitucci, John N.

    Abstract- State and local government pension trusts could become as active investors in capital markets as the private sector's pension trusts. Unlike other plans, however, government trusts are commonly subject to state or local law because they are not usually established as part of qualified plan in accordance with IRC Sec 401(a). Several legal issues must be considered by the trustees of qualified government plans. These include the trustees' fiduciary responsibilities which require them to invested plan assets with great care. Another area of regulation is the types of transactions government plans can enter into. Certain transactions are prohibited to these plans, including the transfer of any asset between a plan and a 'disqualified person.' A third legal consideration is the tax obligation for unrelated business taxable income arising from the plan's investments.

A new step may be for pension trusts to purchase or control companies that are not related to the sponsor of the trust. This approach differs from an ESOP where the pension trust purchases stock of the employer and the company becomes an employee owned company. For example, a pension trust with $20 billion of assets could acquire effective control of a relatively large company independent of the employer for $200 million. It could be argued that such an investment would be prudent and that the trust would be adequately diversified in considering the trust's overall investment portfolio.

Trustees have shied away from this type of ownership or control in the past because of the increased responsibility. However, given changes in our economic environment, the potential for a high rate of return on investments may move pension trust managers in that direction.

This approach differs from pension fund investments in leveraged buy- out (LBO) funds. Pension trusts are generally passive investors in LBO funds and often pay management fees. The debt incurred to purchase the target company of the LBO fund is generally assumed by the target company. Many consider such LBO funds as high risk investments. However, pension trusts invest in such funds and consider them to be prudent. In addition, some pension trusts have invested significantly in junk bonds and real estate.

Large pension trusts could purchase an outside company as an active investor through cash transactions. No debt would be required or assumed by the target company. The trustees could appoint new management, oversee existing management, or hire an independent entity to manage the company. Also, these acquisitions can be implemented by several trusts to share investment risk.

Pension trusts could also make capital contributions to eliminate debt, thereby freeing up resources for expenditures such as increased research and development. Alternatively, the purchase could be made pursuant to an LBO.

Investments of this kind would be undertaken with the expectation of high rates of return, which could result in increased retirement benefits for participants (attracting prospective employees) or create reduced funding obligations, thereby reducing the ongoing cost to the plan sponsor. Alternatively, low rates of return from an unsuccessful investment could ultimately result in an increased cost to the plan sponsor.

Public Employee Retirement Systems

State and local (government) pension trusts could also become active investors. Care would have to be exercised if such trusts purchased a company with the intent of moving it into their jurisdiction, or retaining a company in its jurisdiction that had threatened to leave. Because government pension trusts are not normally established as part of a qualified plan under IRC Sec. 401(a), their freedom to acquire businesses would usually be governed by state or local law. Government plans that aree not "qualified plans" are not subject to the fiduciary standards of ERISA. However, such fiduciaries should be aware that the courts may apply certain ERISA precedents in applying common law fiduciary standards.

Trustees of qualified plans who choose an active investor approach must be aware of three areas of regulation.

Fiduciary Responsibilities

Trustees of qualified plans have fiduciary responsibilities and must make investments with due care. One of the most important responsibilities is assuring that plan assets are appropriately invested.

Under ERISA, a fiduciary is required to discharge his or her duties solely in the interest of the participants and beneficiaries for the exclusive purpose of providing benefits and defraying reasonable expenses of administering the plan. Also, these duties must be exercised with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. A plan fiduciary must diversify plan investments to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.

ERISA does not prohibit plans from engaging in speculative and relatively illiquid investments. However, risks inherent in such investments should be consistent with the above-noted standards considering a plan's overall investment portfolio.

The IRC and ERISA have similar fiduciary, exclusive benefit provisions. An IRS revenue ruling lists four requirements that must be met in order for a plan to satisfy the exclusive benefit rule:

* All investments must be acquired at a cost no greater than fair market value;

* A fair rate of return must be provided;

* The plan must maintain sufficient liquidity to permit distributions; and

* The safeguards and diversity that a prudent investor must adhere to must be present.

Although originally intended to govern purchases of employer stock, the revenue ruling has been extended by subsequent rulings and certain court cases to other plan transactions.

A rule under DOL plan asset regulations provides that when a plan invests in another entity, the plan's assets include its investment, but do not, solely by reason of such investment, include any of the underlying assets of the entity. However, in the case of a plan's investment in an equity interest of an entity that is neither a publicly-offered security nor a security issued by an investment company registered under the Investment Company Act of 1940, its assets include both the equity interest and an undivided interest in each of the underlying assets of the entity, unless it is established that:

* The entity is an operating company (which is an entity that is 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); or

* Equity participation in the entity by pension plan investors is not significant (less than 25%).

Most manufacturing and retail companies should meet the operating company exception.

If a company owned or controlled by a pension trust does not meet the general rules noted above, the underlying assets of the entity are considered plan assets subject to reporting and disclosure requirements of ERISA and any person having a relationship to the underlying assets maybe a fiduciary to the investing plan.

Prohibited Transactions

To ensure that the interest of participants is protected, Congress has identified certain transactions between a plan and party-in-interest (disqualified person) which are deemed to be prohibited transaction under the IRC or ERISA. A disqualified person includes, but is not limited to, an employer who has employees covered by the plan, a fiduciary, an officer, director, and certain direct or indirect owners.

A prohibited transaction includes any direct or indirect:

* Sale or exchange, or leasing, of any property between a plan and a disqualified person;

* Lending of money or other extension of credit between a plan and a disqualified person;

* Furnishing of goods, services, or facilities between a plan and a disqualified person;

* Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;

* Act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in his or her own interest or for his or her own account; or

* Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

To permit transactions that have proven beneficial to plan participants and beneficiaries, ERISA provides for a number of statutory exemptions from the prohibited transaction rules. ERISA also allows the Secretary of Labor to grant a specific exemption from the prohibited transaction rules upon a showing that the exception is:

* Administratively feasible;

* In the interests of the plan and its participants and beneficiaries; and

* Protective of the rights of participants and beneficiaries.

Such exemptions are granted pursuant to an application filed with the DOL, and are granted on a case-by-base basis.

The IRC imposes a 5% excise tax on the amount involved in a prohibited transaction. If the transaction is discovered and not corrected within a certain amount of time there would be an additional 100% tax imposed. A fiduciary may also be subject to a civil penalty for a breach of their fiduciary duties.

It would appear that the plan sponsor of the pension trust could engage in armslength transactions with the company controlled by the pension trust. However, it could be argued that such transactions were a direct or indirect transfer to, or use by or for the benefit of, the plan sponsor of the income or assets of the pension trust. It may be advisable for the plan sponsor to avoid dealings with a company controlled by the plan sponsor's pension trust.

Unrelated Business Taxable Income

A tax-exempt entity, such as a pension trust, is taxable on any items of unrelated business taxable income (UBTI) generated by the investment of the trust. UBTI is defined as the gross income derived by a tax- exempt organization from any unrelated trade or business regularly carried on by it, less the deductions directly related to such business.

If a partnership is regularly carrying on a trade or business, any general or limited partner of the partnership is deemed to be carrying on the trade or business. Thus, a pension fund partner is deemed to be regularly carrying on trade or business when the partnership is deemed to be regularly carrying on a trade or business.

The frequency and continuity with which activities are conducted determine whether a trade or business is "regularly carried on." When the business activity is pursued in a manner similar to comparable commercial activities of taxable organizations and is both frequent and continuous, it will be deemed to be "regularly carried on." An unrelated trade or business is defined as the conduct of an activity that is not substantially related to the purposes of which the organization is exempt.

The following items are generally excludable in determining UBTI:

* Interest, dividends, rentals from real property, royalties, and annuities;

* Gains and losses on sales or exchanges of property other than inventory;

* Securities loaned to a broker followed by the return of identical securities to the lender, including any payments received by the lender for use of the securities; and

* Any gain from the lapse or termination of options to buy or sell securities.

An investment in a publicly traded partnership and certain debt- financed property may lead to UBTI. Any expenses that would be deductible by commercial organizations are also deductible when calculating UBTI.

If a pension trust owns at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation, the pension trust will be considered a controlling organization and the corporation will be considered a controlled corporation. If this is the case, any amounts of interest, annuities, royalties, and rents received by the controlled corporation will be UBTI to the pension trust to the extent such amounts are distributed to the pension trust (e.g., in the form of dividends). The IRC provides a detailed formula in which the UBTI can be determined. However, as indicated above, if the pension trust ownership is less than 80%, this rule will not apply. This rule will also not apply if several independent pension trusts own in the aggregate 100% of a company with no single pension trust owning more than 80%.

If a pension trust obtains control of one or more companies, it could be argued that the pension trust is in the business of buying and selling companies or managing companies, which could possibly be considered carrying on a trade or business. Therefore, care should be taken that all income received by the pension trust is in an exempt form.

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