The New Change in ERISA’s “Fiduciary” Definition and its Effect on Private Fund Managers

Lauren Mack Compliance, Investment Advisers

Broadened Scope of ERISA Fiduciary Rules

After several years of debate and revision, a Department of Labor (DOL) regulation, revising the definition of a “fiduciary” as it applied to investment managers, became applicable on June 9, 2017.  The new regulation expands the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986, as amended, to encompass certain entities and persons which provide nondiscretionary investment advice to pension plans and to individual retirement accounts (IRAs), with certain exemptions.  As a consequence, certain marketing and fundraising activities by private fund managers, if directed to ERISA covered benefit plans (“pension plans”) or to holders of IRAs (collectively, “ERISA-covered assets”), could subject the fund managers to ERISA regulation.[1]  Previously, only those investment managers possessing discretionary control over pension plan assets and client IRAs were considered ERISA fiduciaries, when ERISA-covered assets constituted 25% or more of the fund’s assets under management (AUM). This is still the case now. However, those managers who merely provided investment advice regarding such plans (without discretionary control over assets) were not deemed to be fiduciaries or subject to ERISA.  This has now changed and managers may be deemed fiduciaries despite having no discretionary control over ERISA regulated assets.

The regulation introduces a new category, called “service fiduciaries,” under which fund managers and advisers could become subject to ERISA in connection with a pension plan or IRA’s “decision to invest” in the fund (or to “maintain such investment” in the fund), should the manager provide “investment advice” or “investment recommendations” directly to the pension plan or IRA holder.  In essence, any communications to such investors that are designed to solicit investment or encouragement more of it may constitute “investment recommendations.”

Such “recommendations” are broadly defined by the DOL’s regulation to cover virtually all communications that a “reasonable person” could interpret as a recommendation to buy or sell interests in a fund. This includes obvious sales pitches, as well as recommendations in newsletters or periodical investor reports. It can also cover generalized conversations about the fund with potential investors if encouragement to invest is part of the discussion.

It is important to note that the definition change does not affect the regulations regarding whether the assets of a private fund are treated as “plan assets” as defined under ERISA according to the percentage of pension investment in the fund.  Instead, the regulation sets out a new category that may apply to fund managers regardless of the percentage of plan assets under their management.

Exemptions and the Safe Harbor

There are several carve-outs and exemptions available to fund managers. First, the new regulation includes examples of communications that the DOL would not consider to be “investment recommendations,” such as generalized comments regarding an investment manager’s qualifications and the strategy or performance of a fund, if unaccompanied by investment advice. Marketing materials stressing the performance record of a fund or of an investment manager may not fall under the regulation, but specific advice to pension plan or IRA investors on how to invest or manage their investments definitely falls under the category of “recommendations.”  Some detailed information about the fund’s performance compared to benchmarks, such as would be present in a pitchbook or prospectus, could be considered investment recommendations, however.

The determination of whether a communication is exempt will generally be based on the specific facts and circumstances. There is no bright line rule regarding which communications are exempt and which are covered. It should be noted that the fund manager has the burden of proving that an exemption from the regulation applies. Fortunately, managers may take advantage of a “Sophisticated Investor Safe Harbor,” (the “Safe Harbor”) which enables them to market the fund to institutional investors without becoming ERISA fiduciaries.  While this option is not available for investments made directly by participants in self-directed retirement plans or owners of IRAs[2], it can protect the fund manager with respect to communications made to institutional investors – e.g. most pension plans.

In order to qualify for the Safe Harbor, the pension plan investor must be represented by an independent fiduciary, which must be a bank, insurance company, registered investment adviser (RIA) registered broker-dealer, or an investment manager having at least $50 million in AUM.  Many institutional investment managers will meet this requirement.

Further, the fund manager is not permitted to receive a fee or other compensation for the provision of advice in connection with the transaction (such as an investment management fee or a finder’s fee). Management fees and performance-based compensation are permitted and thus are exempt from the above provision. Additionally, the fund manager must “know or believe” that the independent fiduciary “counts” as a legal fiduciary under ERISA (and/or the definition provided by the Tax Code).[3] This means the fiduciary to which the fund manager pitches the fund must have (1) the responsibility to exercise independent judgment in evaluating the transaction and the (2) appropriate levels of experience and knowledge to evaluate the investment risks.  To prove this is the case, the fund manager can rely on the written representations of the fiduciary.

Next, the fund manager must inform the independent fiduciary that (1) the manager is not undertaking to provide impartial investment advice, (2) nor seeking to give any advice in a fiduciary capacity in connection with the transaction. Furthermore, the fund manager must also inform the independent fiduciary of the nature of the manager’s financial interests in the fund and declare any conflicts of interest that could be present (such as the manager profiting from greater management fees as the fund’s AUM increases with additional subscriptions).

In fund documents, such as private placement memoranda and subscription agreements, there should be clear statements disclaiming provision of investment advice to pension plans and IRAs. Furthermore, subscription documents for new subscriptions and additional investments in the fund made by existing pension plans after June 9, 2017 could contain several additional provisions and plans that such investors relied upon an independent fiduciary and not upon the fund manager in making a decision to subscribe to the fund.  The subscription agreement should clarify that the fund manager is not acting as a fiduciary to those investors.

To a certain extent, existing investors may be “grandfathered in” such that the regulation should not apply with respect to investments in funds that were completed before June 9, 2017.  However, new communications with such investors on or after June, 9 2017 which may be viewed as “investment recommendations” – such as encouragement to remain as investors in the fund – would be subject to review and could result in the manager being deemed a fiduciary. Therefore, fund managers should avoid any communications that may be construed as recommendations; should carefully review periodic and annual reports for such language; and should consider adding a legend to all such regular communications declaring that these publications are neither intended to be, nor should be construed as, investment advice to ERISA covered investors.

Finally, the new definition does not affect investments made by pensions and IRAs of the owners of the investment manager (and by other “friends and family” investors) provided that (1) such investors are not paying management fees to the fund manager; and (2) such investors are not subject to incentive/performance-based compensation of the manager or its affiliates.

[1] Being deemed an ERISA plan fiduciary has several important consequences for private fund managers.  Certain highly leveraged investments are prohibited for such individuals, and some common trading strategies could be significantly curtailed. ERISA imposes high standards of care on a manager’s investment choices: fiduciaries that violate the ERISA standards of care are personally liable for any losses incurred by pension plans that have invested in the fiduciary’s fund; other fines may also be levied on the fund and the manager.  To avoid implicating these rules, many funds limit investments by pension plans to below 25% of the fund’s assets under management.

[2] “Recommendations” provided to an unrepresented IRA, to a participant in a self-directed 401(k) plan or to smaller ERISA Plans (i.e., where the plan manager controls less than $50 million) will not fall under the Safe Harbor. Providing recommendations to such entities may cause the fund manager to be a fiduciary when such investors subscribe to the fund. Thus, private fund managers may wish to prohibit new investments by this category of investor and state this clearly in fund documents.

[3] See 29 CFR 2510.3-21, 26 U.S. Code § 7701

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