A legal dispute involving an Arizona real estate development company has led to a rare court decision considering the “real estate operating company” (REOC) exception under the “plan asset” regulations of the Employee Retirement Income Security Act of 1974 as amended (ERISA). Under ERISA, the manager of a non-publicly traded entity in which an ERISA plan has a substantial equity interest may be held to ERISA fiduciary standards in managing that entity unless, e.g., the entity is an “operating company” (as distinguished from a passive investment entity) such as a REOC.

In Hart Interior Design LLC 401k Profit Sharing Plan v. Recorp Invs. Inc., 2018 BL 147891, D. Ariz., No. 2:16-cv-02347-GMS (order on summary judgment motions, April 26, 2018):

  • An ERISA plan (Plan) purchased a 28% interest in a real estate development company (Carinos), which in turn acquired more than 1,250 acres of undeveloped New Mexico land and was managed by an affiliate (RII) of the business principal.
  • Some years later, by reason of state court actions on defaulted loans to the principal, an institutional lender/investor (IMH) acquired an indirect 36% interest in Carinos and ownership of RII.
  • IMH brought state court actions against Carinos to recover on an alleged secured debt executed by the principal and for unpaid management fees due to RII. The investors in Carinos were notified that it lacked funds to defend the lawsuits, and the Plan intervened to prevent default by Carinos.
  • The Plan then brought a federal court action under ERISA against IMH and RII, alleging they were ERISA fiduciaries by reason of their management responsibilities for Carinos and breached their duties under ERISA by pursuing unmerited litigation against Carinos and failing to provide certain material information requested by the Plan concerning the management of Carinos.
  • IMH and RII defended the action on the basis they were not ERISA fiduciaries, arguing in part that Carinos was a REOC, and moved for summary judgment.

In ruling that the record did not support summary judgment for the defendants, the court reasoned Carinos was not a REOC and:

  • To qualify under the REOC definition during each 12-month time period measured from an “initial valuation date,” Carinos must “in the ordinary course of its business [be] engaged directly in real estate management or development activities.” (The other elements of the REOC definition were not in dispute.)
  • While Carinos may have undertaken such activities in prior years, it was on the facts engaged solely in the passive holding of undeveloped real properties during the 12-month periods when the alleged fiduciary breaches occurred.
  • Instead, the record on summary judgment showed that any real estate management or development activities during the time period in question (primarily, concerning water resources on the property) were being undertaken directly by IMH, rather than by Carinos.

Eversheds Sutherland Observations

  • Any case that applies the plan asset regulation, much less the REOC exception, is worthy of attention.
  • This case specifically illustrates both (i) the subtleties of the timing rules embedded in the REOC definition and (ii) the importance of observing the formalities of business organizations in conducting management or development activities, if REOC status is to be maintained.
  • In discussing whether the allegations of fiduciary breach survived the summary judgment motion, the court also came to the interesting conclusion that IMH’s and RII’s conflict of interest in pursuing claims against Carinos was not a per se ERISA fiduciary breach (assuming they are ultimately held to be fiduciaries at trial), but there could be a breach if the debts and fees on which those claims are based prove not to be legitimate.