Prohibited Transactions and Their Consequences in Private Equity & Venture Capital
In the realm of private equity (PE) and venture capital (VC) transactions, understanding and adhering to regulations is paramount. One critical area of compliance, particularly when employee benefit plans are involved, is the prohibition of certain transactions. These 'prohibited transactions' are designed to protect plan assets and beneficiaries from self-dealing and conflicts of interest. Failure to comply can lead to severe penalties.
What are Prohibited Transactions?
Prohibited transactions are defined by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC). They generally involve any direct or indirect:
- Sale, 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 any assets or income of a plan.
- Act by a disqualified person who is a fiduciary whereby the assets of the plan are used for his own interest or for his own account.
Who are Disqualified Persons?
A 'disqualified person' (also known as a 'party in interest' under ERISA) is broadly defined and includes:
- The plan sponsor (e.g., the PE/VC firm).
- The plan fiduciaries (e.g., trustees, investment managers).
- Employees of the plan sponsor.
- Corporations or partnerships in which the plan has significant ownership.
- Certain relatives of individuals listed above.
- Entities providing services to the plan.
Consequences of Prohibited Transactions
The penalties for engaging in prohibited transactions can be severe and multifaceted, impacting both the disqualified person and the plan itself. These consequences are designed to deter such activities and to make the plan whole if harm occurs.
| Consequence Type | Description | Applicable Law |
|---|---|---|
| Excise Tax | A significant excise tax (initially 5% of the amount involved, potentially increasing to 100% if not corrected) is imposed on the disqualified person. | Internal Revenue Code (IRC) Section 4975 |
| Plan Disqualification | The plan may lose its tax-exempt status, leading to immediate taxation of all trust earnings. | Internal Revenue Code (IRC) |
| Civil Penalties | Fiduciaries may face personal liability for losses to the plan and disgorgement of profits. | ERISA Section 409 |
| Injunctions and Removal | Courts can issue injunctions to stop prohibited transactions and remove fiduciaries. | ERISA Section 502(a)(2) & (a)(5) |
| Restitution and Recoupment | The disqualified person may be required to make restitution to the plan for any losses incurred and to return any profits made from the prohibited transaction. | ERISA Section 409 |
Exemptions and Relief
While the prohibitions are strict, ERISA and the IRC provide for certain exemptions. These can be statutory (automatically available) or administrative (requiring an application to the Department of Labor). Common exemptions include:
- Transactions between a plan and its sponsor, provided they are on arm's-length terms and for adequate consideration.
- Providing services to a plan by a disqualified person, if the services are necessary for the plan's operation and are furnished on a reasonable contract or arrangement.
- Loans to participants and beneficiaries for their primary residences.
Navigating these exemptions requires careful legal counsel to ensure compliance.
The 'adequate consideration' and 'arm's-length' standards are crucial when relying on exemptions. They mean the transaction must be no less favorable to the plan than it would be if it were with an unrelated third party.
Practical Implications for PE/VC
For PE and VC firms that manage funds which may include investments from ERISA plans (e.g., pension funds, 401(k) plans), understanding prohibited transactions is vital. This includes:
- Due Diligence: Thoroughly vetting all transactions involving plan assets.
- Structuring: Carefully structuring investments and service agreements to avoid triggering prohibited transaction rules.
- Compliance Programs: Implementing robust internal compliance programs and seeking expert legal advice.
- Record Keeping: Maintaining meticulous records of all transactions and decisions.
The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC).
Sale, exchange, or leasing of property; lending of money; furnishing of goods, services, or facilities; transfer or use of plan assets for the benefit of a disqualified person.
A significant excise tax (initially 5%, potentially 100% if uncorrected).
Learning Resources
Official overview from the Department of Labor on ERISA's prohibited transaction rules, providing foundational understanding.
A clear explanation of prohibited transactions, disqualified persons, and common pitfalls for plan sponsors and fiduciaries.
While broad, this IRS publication touches upon rules relevant to qualified plans, including aspects that can intersect with prohibited transaction concerns.
Information from the Department of Labor detailing the process and types of exemptions available for otherwise prohibited transactions.
An explanation of fiduciary duties under ERISA, which are intrinsically linked to the prevention of prohibited transactions.
An article discussing practical strategies and considerations for avoiding prohibited transactions in ERISA-governed plans.
A legal perspective on Class Prohibited Transaction Exemptions (PTEs) and their application in various scenarios.
Focuses on the specific challenges and considerations for private equity firms dealing with ERISA plan investors.
An overview of recent trends and key considerations in litigation related to ERISA prohibited transactions.
A resource from the Pension Benefit Guaranty Corporation (PBGC) explaining the basics of prohibited transactions and available exemptions.