The Department of Labor’s New Regulations Defining Advice Fiduciary
What Hedge Fund Managers Should Do Now
In April 2016, the Department of Labor (“DOL”) released regulations that expanded the definition of an “advice fiduciary” with respect to plans covered by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and IRAs and other plans covered by Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”). The expanded definition generally might be interpreted as treating investment managers as “advice fiduciaries” with respect to such investors in funds that they manage unless certain exceptions are met.
The new rule, in relevant part, will apply to investments in funds by ERISA plans and IRAs (including additional investments by existing ERISA plan and IRA investors) made on or after June 9, 2017. Thus, the new rule will generally apply to investments by such investors on or after July 1, 2017, for funds that accept subscriptions on the first of the month.
At this point, it does not appear that the new rule will be further postponed or repealed before then, as some expected, although it might be retroactively changed. In light of the approaching effective date, hedge fund managers should make changes to their fund documents to take the new rule into account. Such changes may take the form of an addendum until the Fund documents are otherwise revised. The new rule does not apply to existing investments by such investors. Managers should also include a statement in any communications (e.g., emails) with such investors that they are not acting as fiduciaries with respect to such investors.
If an investment manager is considered to be an advice fiduciary then the manager’s fees could be called into question with respect to ERISA or IRA investors. Therefore, an investment manager will want to avoid being considered an advice fiduciary. The new rule applies with respect to investment managers of funds which are plan asset funds (i.e., those that exceed the 25% benefit plan investor test) as well as investment managers of funds which are not plan asset funds.
Independent fiduciary exception. There is an important exception to the new rule that funds should implement, however. This exception is for investments by investors that have independent fiduciaries who have financial expertise and certain conditions are satisfied.
Under the rule, an independent fiduciary is a plan fiduciary that is:
(i) a U.S. regulated bank;
(ii) a U.S. regulated insurance carrier;
(iii) a U.S. or state registered investment advisor;
(iv) a U.S. registered broker-dealer; or
(v) a fiduciary with at least $50 million of assets under management.
To meet the independent fiduciary exception, the investment manager should obtain certain representations in the fund documents from such investors, including that the independent fiduciary is acting as a fiduciary under ERISA or the Code, or both, with respect to the investment and is capable of evaluating investment risk, both in general and with respect to the particular investment in the fund. The investment manager should inform the independent fiduciary that the investment manager is not providing impartial investment advice or giving advice in a fiduciary capacity. The investment manager cannot receive a fee or other compensation directly from the ERISA plan, IRA, or IRA owner for the provision of investment advice in connection with an investment in a fund and a representation should also provide this.
Small ERISA plan investors and IRA investors generally may not be able to meet the independent fiduciary exception. Some large investment managers have decided not to take any further investments from such investors who cannot meet the independent fiduciary exception. Smaller investment managers, for example, may decide to continue to accept investments from such investors because investments from such investors may be more significant to them. Investment managers that want to continue to accept investments from IRAs and small plan investors (including new investments from existing IRAs and small plan investors) may be able to rely on representations from IRA or small plan investors that the investment manager has not solicited, provided investment recommendations, or been relied upon with respect to an investment in the fund by the IRA or small plan investor.