DOL Fiduciary Rule: Impact on Hedge Fund Managers

Background

On June 9, 2017, the Department of Labor (“DOL”) effected a new regulation  expanding the definition of a “fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”) and Section 4975 of the Internal Revenue Code of 1986 (“Code”) (the “Fiduciary Rule”). Prior to the publication of the Fiduciary Rule, investment managers of private funds could effectively avoid designation as an ERISA fiduciary by limiting the aggregate investment in a fund by ERISA-covered plans and Individual Retirement Accounts (collectively, “Benefit Plans”) to less than 25% of the fund’s total assets under management (“AUM”).

While the 25% AUM exemption is still in place at the fund level, the Fiduciary Rule creates a new set of circumstances under which a fund manager could be deemed a fiduciary as a result of providing investment advice to a Benefit Plan in connection with the Benefit Plan’s “decision to invest” or to “maintain an investment” in a fund. Under the new rule, fund managers that make recommendations to Benefit Plans regarding the advisability of a particular investment or management decision are considered fiduciaries. The Fiduciary Rule defines recommendation as “a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.”

What does this mean for Fund Managers?

Due to the broad definition of the term recommendation, this means that fund managers may become subject to ERISA fiduciary obligations simply by communicating with a Benefit Plan investor regarding its decision to invest in or withdraw from a fund, including the decision to maintain or increase an investment in a fund. The Fiduciary Rule does provide some examples of communications that would not be considered investment recommendations, such as general circulation newsletters, remarks and presentations at speeches and conferences, general market data, and performance reports. In contrast, if a fund manager were to recommend a particular fund (including any fund in which it manages), discuss withdrawal or reallocation of funds, or tailor advice to a particular Benefit Plan, such communication would likely be deemed investment advice and subject the manager to ERISA fiduciary obligations.

Safe Harbor

The Fiduciary Rule contains a key safe harbor for Benefit Plan transactions conducted through independent fiduciaries with financial expertise (the “Safe Harbor”). Specifically, fund managers will not be classified as ERISA fiduciaries if:

1. The fund manager provides the above-described recommendations to an independent fiduciary;
2. The fund manager knows and receives assurances that the independent fiduciary (i) has the responsibility to act as fiduciary for the Benefit Plan and (ii) appropriate experience and knowledge to do so;
3. The fund manager discloses to the independent fiduciary that the manager is (i) not undertaking to provide impartial investment advice and (ii) not giving advice in a fiduciary capacity; and
4. The fund manager receives no compensation in connection with the investor’s decision to invest in the fund.

For the purposes of the Safe Harbor, the Fiduciary Rule defines independent fiduciaries as:

1. A U.S. regulated and supervised bank;
2. A U.S. qualified insurance carrier;
3. A federal or state investment adviser;
4. A registered broker-dealer; or
5. An independent fiduciary that holds, manages, or controls assets of at least $50 million.

Options for Fund Managers

Fund managers with mostly larger, institutional clients may elect to solely accept funds from Benefit Plans represented by an expert fiduciary. While this would prevent these fund managers from receiving compensation in connection with the transaction (i.e. investment management fee or finder’s fee), it would still allow the collection of management fees and performance allocations on fund assets. We advise fund managers that solely elect to accept expertly managed Benefits Plans to update their offering documents to include (i) disclosures that the fund manager is not acting as a fiduciary and (ii) representations from each Benefit Plan investor that contain sufficient information to establish the transaction qualifies for the Safe Harbor.

Fund managers that elect to accept non-expertly managed Benefit Plans, however, should take precautions to ensure no advice is given to make or maintain an investment in a fund.  Fund managers that provide such advice may be classified as fiduciaries of these non-expertly managed Benefit Plans, which would subject any management fee and performance allocation to scrutiny under the prohibited transactions provision of Section 4975 of the Code, primarily involving fiduciary conflict of interest issues.  With these considerations in mind, we advise fund managers that elect to accept non-expertly managed Benefit Plans (such as self-directed IRA and 401(k) plans and small ERISA Plans) to do the following:

1. Assess whether current Benefit Plan investors fall under the Safe Harbor or another exemption. Investments made by Benefits Plans of the owners of a fund manager and “friends and family” investors would not be subject to the Fiduciary Rule if the investors are not paying fees to the fund manager and not subject to a performance allocation.
2. Review all marketing and communication material to current or prospective investors to ensure that communications could not be perceived as a recommendation to invest maintain an investment in the fund.
3. Attach or incorporate disclosures into the offering documents that the fund manager is not acting as a fiduciary and that nothing in the offering documents should be construed as ERISA fiduciary investment advice.

While fund managers may elect to take the above-listed precautions, given the uncertainty of how the DOL will enforce the Fiduciary Rule, the wisest option may be to refrain from taking on new Benefit Plan investors and/or taking additional contributions from existing Benefit Plan investors that are not represented by an expert fiduciary. The above-steps are general guidelines, and fund managers that elect to continue to accept capital from non-expertly managed Benefit plans should have their offering and marketing materials reviewed by qualified counsel to ensure the materials do not contain any information that could be deemed an investment recommendation. Even fund managers that solely elect to accept capital from expertly managed Benefit Plans should consult counsel to ensure the terms of the Safe Harbor are met with respect to each Benefit Plan investor.

Future of the Fiduciary Rule

Although the rule has already gone into effect with relaxed oversight, the DOL issued a temporary enforcement policy stating it will not take enforcement action against persons working diligently and in good faith until January 1, 2018. While the DOL has indicated it will not overturn the Fiduciary Rule without legal cause, it has also stated it will continue its review of the Fiduciary Rule during this transitional period. The current administration has voiced strong opposition to the Fiduciary Rule, and the proposed Financial CHOICE Act, which recently passed in the House, could potentially repeal the Fiduciary Rule (although the Act has not garnered much traction in the Senate).

We will continue to closely monitor developments regarding the Fiduciary Rule. In the meantime, feel free to reach out to us if you have any questions concerning the Fiduciary Rule or need assistance updating existing fund subscription documents to address the new rule.