Due to the application of ERISA, pension funds have historically had limited access to commercial mortgaged backed securities ("CMBS"). The Bond Market Association is sponsoring an effort to obtain Department of Labor relief that would expand the categories of CMBS that may be sold to plans subject to ERISA.
Currently, only the most senior class of any CMBS offering is generally eligible for purchase by employee benefit plans subject to ERISA. This is because under many CBMS structures, when investment by pension funds in any class of CMBS is significant (generally, 25% or more of that class), ERISA "looks through" to the assets of the vehicle. Thus, ERISA treats such assets as assets of the pension fund investors for the purpose of the application of ERISA’s fiduciary requirements. As a result of the application of ERISA to the assets of the issuer, many transactions commonly part of the structure and operation of a CMBS vehicle may violate ERISA. In addition, the investment in CMBS by a pension fund could result in a prohibited transaction under ERISA if the sponsor, servicer, trustee, or any of the mortgagors on the mortgages held by the issuer is a "party in interest" under ERISA with respect to that pension fund.
The Department of Labor has granted individual exemptions (commonly referred to as "underwriter exemptions") to over 45 investment banks that provide relief from the application of the ERISA prohibitions for the purchase by pension funds of certain types of asset-backed securities, including CMBS. The exemptions are limited, however, to only unsubordinated, highly rated (single ‘A’ and above) securities. To date, the Department of Labor has declined requests to expand the scope of the exemptions for the sale of CMBS. Accordingly, most sponsors of CMBS vehicles prohibit investment by pension funds except in the most senior, highly rated tranche of a CMBS offering.
The Bond Market Association exemption application was filed on October 22, 1999 on behalf of a single named applicant - Morgan Stanley Dean Witter & Co. But, if granted, would be extended to qualifying CMBS offerings placed or underwritten by all firms that have an underwriter exemption. The proposal would extend exemptive relief to subordinate tranches of CMBS, provided that they receive at least an investment grade (‘BBB’ and above) rating at the time of its purchase by employee benefit plans. It is uncertain at this time whether the Department of Labor will agree to the proposed expansion of exemptive relief, or how long it will take the Department of consider the application.
Even if an amendment to the underwriter exemptions is granted in the form proposed, ERISA plans will still not be permitted to invest directly in below-investment-grade CMBS. Plans may invest in CMBS indirectly, however, through real estate operating companies ("REOCs") or other vehicles that are not deemed to hold plan assets of their plan investors. A REOC that invests in CMBS must limit its CMBS holdings to less than 50% of its assets in order to satisfy the requirement that a REOC have at least 50% of its assets invested in managed or developed real estate with respect to which it has the right to participate substantially in the management or development activities.
Copyright (c) 1999 Mayer, Brown & Platt. This Mayer, Brown & Platt publication provides information and comments on legal issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.