For decades, private funds have had to decide whether to accept "significant" investment by benefit plan investors (i.e., ERISA plans and IRAs) under the so-called plan asset regulation under ERISA. The new ERISA and Internal Revenue Code fiduciary definition scheduled to go into effect later this year may cause fund managers to ponder whether to permit any benefit plan investment at all, even if insignificant enough to avoid fiduciary responsibility in managing the fund's assets.
Plan Asset Regulation
If an ERISA pension plan or IRA invests in a fund or other entity, it will be deemed to own not just the equity interest itself but a proportionate share of any assets owned by the entity, unless an exception to the ERISA "look-through" rule applies. The exceptions most utilized by private funds are the "25% test" or operation as either a venture capital operating company ("VCOC") or a real estate operating company ("REOC"). Other exceptions for investment in operating companies, debt instruments with no substantial equity features, publicly offered securities and registered mutual funds — are not typically available to private funds.
If a fund does not qualify as a VCOC or a REOC, it will be a plan asset entity unless benefit plan investors own less than 25% of each class of its equity, measured at each redemption, sale or purchase of any equity interest and disregarding the equity owned by any person (or its affiliate) with discretionary authority over the fund's assets or that provides investment advice to the fund for a fee. However, class is not defined by the plan assets regulation, and experts differ as to whether local law (where the fund is domiciled) or definitions under U.S. securities law should apply to determine when variations in legal or economic rights attached to investors' interests create separate classes.
ERISA Fiduciary Standards
If the look-through rule applies to a fund, the assets of the fund have to be managed in accordance with ERISA. The manager not only must act for the exclusive benefit of the participants of the plan investors, avoiding any form of self-dealing that is not covered by a specific statutory, class or individual exemption, but also must perform to the standard of a "prudent expert." While simple disclosure of potential and actual conflicts may be cleansing under other laws, disclosure is generally insufficient to prevent an ERISA violation by a fiduciary who acts in his own self-interest in managing plan assets. Even generally accepted compensation arrangements that could potentially affect the manager's judgment to the detriment of the interests of the plan investors may have to be identified and adjusted.
Prohibited Transactions and QPAM Exemption
As a fiduciary, a fund manager would also have to avoid otherwise benign transactions between the fund and any party-in-interest to a plan investor, which would include the plan sponsor, fiduciaries to the plan, other service providers to the plan and various affiliates of each. Such "prohibited transactions" carry not only significant excise tax penalties for the party-in-interest, but also potential personal liability for the fiduciary for any losses that result from the original transaction or its unwinding (that may be required to prevent the excise tax from growing from an initial 15% to 100%). If the fund manager is a qualified professional asset manager ("QPAM"), however, transactions between the fund and a party-in-interest to a plan investor would generally be exempt provided neither the party-in-interest nor one of its affiliates had the power to appoint the manager. Although not a perfect solution, the QPAM exemption can solve a multitude of potential problems for the manager of a plan asset fund.
Fee Disclosure
A manager of a plan asset fund, as a party-in-interest to the fund, would be prohibited from receiving any compensation from the fund for its services absent an available exemption. Regulations under Section 408(b)(2) of ERISA (which provides a statutory exemption for reasonable arrangements between a plan and a service provider to the plan) require disclosure of all direct and indirect compensation received in connection with such services and additional information relating to transaction charges and operating and other expenses in the case of fiduciary services to a plan asset entity.
Impact of the New Fiduciary Definition
Although the new fiduciary definition was primarily aimed at brokers and investment advisers in the retail market, it will affect how private funds are marketed to benefit plan investors. Unless the Trump administration rescinds or materially modifies the regulation, the revised definition will expand fiduciary advice to include recommendations regarding the purchase and sale of investments, in addition to the actual management of investments. Accordingly, marketing fund interests to potential benefit plan investors could put the fund manager or its sales personnel in the position of giving fiduciary advice under ERISA, even if managing the assets of the fund had no fiduciary implications under ERISA because the fund is not a plan asset vehicle (either by virtue of keeping benefit plan investors under the 25% limit or by operating as a VCOC or a REOC).
Hire-Me Exception
Although the Department of Labor has indicated that it did not intend an investment manager to become a fiduciary merely by engaging in the normal activity of marketing itself or an affiliate as a potential fiduciary, the application of the so-called hire-me exception is unclear. Many ERISA lawyers who work extensively in the private fund space believe investing in a private fund is tantamount to hiring an investment manager and are comfortable that the hire-me exception should apply; others look at the differences in the legal rights and restrictions on a fund subscriber as compared with simply hiring an investment adviser to manage a separate account and are not so sure.
Independent Fiduciary Exception
Investment recommendations made to an independent fiduciary of an ERISA plan or IRA investor in an arm's-length transaction are not fiduciary advice under the new definition, provided the independent fiduciary is financially sophisticated. To satisfy this exception, the investment manager (i) must know or reasonably believe that the independent fiduciary (a) is a U.S. bank or insurance company, a U.S. registered investment adviser or broker-dealer, or a fiduciary that holds, manages, or controls at least $50 million of assets, (b) is capable of independently evaluating investment risks and (c) is the ERISA or Internal Revenue Code fiduciary responsible for exercising independent judgment with respect to the transaction; (ii) must inform the independent fiduciary that it is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity with respect to, and discloses to the independent fiduciary the existence and nature of its financial interests in, the transaction; and (iii) must not receive a fee or other compensation directly from the benefit plan investor or independent fiduciary for the provision of investment advice (as opposed to a fee for other services) in connection with the transaction. These requirements can be satisfied by representations and covenants in the investment management agreement, subscription agreement, side letter or comparable documentation executed by the benefit plan investor in connection with the transaction.
It is important to note that this exception does not cover advice to fiduciaries of small plans, individual plan participants or IRA owners, however much money they have to invest. Consequently, high-wealth individuals with ERISA or IRA assets cannot be independent fiduciaries under this exception, and fund marketing efforts would have to fit within the more uncertain hire-me exception, or be limited to general communications that a reasonable person would not consider an investment recommendation, to avoid fiduciary responsibility for their becoming fund investors. "Friends and family" may be a category of potential investors particularly difficult to fit within an exception under the new definition.
Future of the New Fiduciary Definition
The Trump administration has already moved to place a moratorium on finalizing new regulations it has not had the opportunity to approve. The memorandum released Jan. 20 contemplates a 60-day delay from that date, which would not affect the timing of the new fiduciary definition, which isn't scheduled to go into effect until April 10, 2017. The Jan. 20 memorandum also encourages department heads to propose further delays for notice and comment, as appropriate. A permanent repeal or major rewrite would require a new round of proposed regulations with an extended comment period, unless Congress intervenes with a statutory fix. Given the long list of promised actions President Donald Trump and House Republicans have on their respective plates, both the near- and long-term future of the new fiduciary definition is unclear. The plan asset regulation, however, does not appear to be on anyone's agenda for a major overhaul, so repeal of the new fiduciary definition would still leave the dilemma of becoming, or not becoming, an ERISA fiduciary to a fund with substantial benefit plan investors.
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