The ERISA “Plan Asset” rule is complex, and the world of sophisticated financial instruments makes its application even more challenging. A good example of this involves a master feeder hedge fund arrangement involved in international investment. Such an arrangement may experience unexpected complications when “hardwiring” its feeder funds for ERISA purposes if the feeder funds issue classes denominated in US currency, but the base currency of the master and/or feeder funds is a non-US currency.

The “look-through rule” under the US Department of Labor’s (DOL’s) Code of Federal Regulations §2510.3-101 (the DOL Regulations) provides that, unless an exception applies, the assets of a “Benefit Plan Investor” (as defined under Section 3(42) of ERISA and the DOL Regulations as modified by Section 3(42) of ERISA) (together, the “Plan Asset Rule”) that acquires an equity interest in another entity, such as a hedge fund, are treated as including both the equity interest itself and an undivided interest in each of the underlying assets of that entity. This potentially poses significant prohibited transaction and other ERISA fiduciary issues that must be addressed.

A major exception to the look-through rule applies if Benefit Plan Investors hold less than 25% of the value of each class of an entity’s equity interests. When calculating the percentage of a class of equity that Benefit Plan Investors hold, an entity must disregard the value of interests that persons (other than Benefit Plan Investors) hold who have discretionary authority or control with respect to the assets of the entity or provide investment advice for a fee (direct or indirect) with respect to the assets of the entity and their respective “affiliates.” Thus, the equity that the investment manager and/or general partner of a hedge fund or its affiliates own is disregarded in the numerator and denominator of the fraction used to determine whether the percentage of each class of equity that the Benefit Plan Investors hold compared to that of the total investors in such class is less than the 25% threshold.

For tax purposes or other reasons, a master feeder hedge fund structure is often used to create a master fund and both an offshore feeder through which tax exempt and non-U S investors invest (including Benefit Plan Investors) and an onshore feeder through which US taxable investors invest. When feeders are authorized to invest “substantially” all, but not all, of their assets in a master fund, and one of the feeders has exceeded the 25% threshold, the feeder’s non–Benefit Plan Investor assets will be considered equity invested in the master fund by an “affiliate” of the general partner and investment manager of the master fund because of their ability to exercise a controlling influence over the management or policies of the feeder funds. As a result, all of the feeders’ non–Benefit Plan Investor allocable assets invested in the master fund are disregarded in the 25% threshold calculation at the master fund level, and the master fund will be deemed to have 100% ERISA “plan assets” under the Plan Asset Rule, thus precluding the exception’s application.

To avoid this result, in the event that either feeder fund exceeds the 25% threshold, a technique is commonly used whereby both feeder funds become “hardwired” so that neither the general partner nor the investment manager is deemed to have any discretionary authority or control over managing or investing either feeder fund’s assets. This allows the 25% threshold to be calculated at the master fund level with the hardwired feeder funds’ non–Benefit Plan Investor assets continuing to count in the numerator and denominator of the master fund’s 25% threshold fraction. This enables a greater amount of Benefit Plan Investor contributions to be accepted at the master fund level before the master fund is deemed to have “plan assets.”

However, this approach is not without complications. For example, where a master feeder hedge fund arrangement offers separate classes at the feeder fund level denominated in different currencies, issues may arise that might prevent the feeders from being considered completely hardwired. Because currency hedging forward contracts are assets purchased solely to benefit the particular investors who invest in specific currency denominated classes whose currency denominations differ from that of the feeder or master fund’s base currency under the Plan Asset Rule, those contracts will be considered the separate property of such investors and must be tested as a separate entity under the 25% threshold test.

In the usual situation where funds’ base currency is in US dollars, the above scenario does not normally cause a problem because Benefit Plan Investors rarely ever exceed the 25% threshold with respect to non–US-dollar denominated feeder fund classes, and no currency hedges are purchased for Benefit Plan Investors that invest in US-dollar denominated classes. Therefore, applying the separate property rule to currency forward contracts does not usually create a “plan asset” separate entity that must be hardwired, even if the related feeder fund itself exceeds the 25% threshold and the actions of the investment manager and/or general partner must therefore be hardwired with respect to operating the feeder funds and managing their other assets.

In contrast, we are increasingly seeing managers establish hedge funds in an expanding list of non–US jurisdictions, where the funds’ base currency is not in US dollars. For example, take the case where the master fund and the feeder funds are formed in Japan and their base currencies are in yen, but Benefit Plan Investors hold interests in US-dollar denominated feeder fund classes. The feeder funds may be set up to allow the feeders to exceed the 25% threshold, anticipating that the feeder fund hardwiring techniques discussed above with respect to the feeder funds’ operation and asset management will apply to help prevent the master fund from having “plan assets.” However, in this situation, because Benefit Plan Investors are investing in a US-dollar denominated class of interests at the offshore feeder fund level, Benefit Plan Investors’ interests in the “separate entity” relating solely to the currency forward contracts may well exceed the 25% threshold, and hardwiring the actions of the investment manager and/or general partner with respect to such contracts is not a routine matter. This structure raises a number of issues that require further consideration, and we are happy to discuss any questions with respect to these issues further.