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— Judgment Call —
Further, the letter set forth the office's view that plan fiduciaries are obligated to have in place a process to independently assess the valuation of alternative investments, such as private equity funds. Although the Boston office is DOL's only regional branch to have adopted such a position, its letter has already sent shockwaves through the pension plan community, and as a result, some private equity funds may find themselves faced with a choice between accommodating plan investors' need for increased transparency and potentially losing pension dollars. ERISA does not set forth specific rules for plan investments in private equity but rather imposes on plan fiduciaries (that is, people with authority and discretion to manage the assets of the plan) a duty to act prudently and solely in the interest of plan participants and beneficiaries. Plan fiduciaries must determine that each investment is reasonably designed as part of the plan's portfolio to further the purposes of the plan. In doing so, they must consider the risk of loss, the opportunity for gain, the extent of the portfolio's diversification, the portfolio's liquidity and the investment's projected return. Plan fiduciaries have an ongoing duty to evaluate whether an investment remains a prudent investment for the plan and are personally liable for breaches of their duties under ERISA.
On July 1, the Boston office sent a letter -- commonly referred to as a 10-day letter because of the amount of time given to respond -- to an unidentified plan alleging that its fiduciaries violated their duties under ERISA by relying on unaudited financial statements and capital account balance statements prepared by the general partners of the plan's alternative investments. The valuations from the statements were used to complete the schedule of the plan's assets and liabilities required to be submitted as part of its annual Form 5500. The office took issue with the fact that the fiduciaries valued at least one investment at cost while faulting them for failing to have procedures in place to assess the validity of their alternative investment fund's valuation contained in its valuation statements. Specifically, the office said: "it is incumbent on the [plan fiduciary] to establish a process to evaluate the fair market value of any hard-to-value assets held by the plan," and "[a] process which merely uses the general partner's established value for all funds without additional analysis may not insure that the alternative assets are valued at fair market value." It is unclear what plan fiduciaries must do to satisfy such a standard, but at the very least, they should "have a thorough knowledge of the general partner's valuation methodology to assure it comports with the fund's written valuation provisions and reflects fair market value." Even if the letter is only ostensibly the Boston office's position, many see it as the first step toward DOL addressing concerns that alternative investments lack transparency. The ERISA Advisory Council, a statutorily-created 15-member group that studies and makes recommendations about various ERISA-related issues, urged DOL to publish guidance in 2006 for plan fiduciaries making alternative investments, and has engaged in fact-finding meetings about the pricing of direct investments in hard-to-value assets, including private equity funds. In August, the Government Accountability Office raised concerns that plan fiduciaries often find it difficult to value private equity investments and also recommended that DOL provide specific guidance to plan fiduciaries with respect to investments in private equity funds. DOL's national office has so far resisted such calls, questioning the feasibility of developing effective guidance, but the Boston office's letter may foreshadow future enforcement initiatives either at the national or regional level. Regardless of whether DOL ever explicitly adopts the Boston office's position, the July 1 letter will, in the short term, lead to increased pressure on private equity funds by current and prospective plan investors to enhance operational transparency. In an effort to gain a "thorough knowledge" of fund valuation procedures, many plan fiduciaries will reject the vague descriptions of valuation procedures typically contained in fund partnership agreements or other governing documents. They will instead insist that the fund's general partner contractually obligate itself to abide by detailed valuation procedures, either through side letter agreements or amendments to the fund's governing documents. In particular, corporate plan fiduciaries, who are often intimately familiar with generally accepted accounting principles, will be looking for periodic independent valuations and verification that the fund auditor uses a market-based determination of the fair value of portfolio investments in accordance with FAS 157 and equivalent standards abroad. Many corporate plan fiduciaries will also require additional disclosures to meet their own company's obligation to disclose information about their plans' invested assets when FAS 132 goes into effect. Additionally, plan fiduciaries will likely begin demanding evidence that fund audits are conducted in a manner consistent with written procedures, which may necessitate the disclosure of portfolio specific data. In short, the Boston office's letter will serve to exacerbate the inherent tension between plan investors' need for detailed information and the reluctance of private equity to divulge proprietary information about investments and operations. Consequently, many private equity funds will be faced with a dilemma: accept pension plan investments and risk the release of proprietary information or maintain current practices and risk losing pension dollars. Michael P. Kreps is an attorney at the Groom Law Group, Chartered, where his practice focuses on ERISA's fiduciary responsibility provisions. Comments |
In a move likely to have a significant impact on private equity funds, the Department of Labor's Boston office recently issued a letter alleging that pension plan fiduciaries violated the Employee Retirement Income Security Act of 1974, or ERISA, by relying on investment valuation reports provided by the PE fund manager or general partner. 
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It will be very interesting to see how PE firms respond!