Here’s another article from Forbes written by Adam Bergman –
On June 9, 2017, the Department of Labor’s (DOL) final rule meaningfully expanded when a person is deemed to be treated as a fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (Code) as a result of providing investment advice. The final rule was initially set to become applicable on April 10, 2017, but the DOL delayed the final rule’s applicability date for sixty days, until June 9, 2017 and also issued a new temporary enforcement policy for the transition period commencing on June 9th and ending on December 31, 2017.
Under the Fiduciary Rule, various marketing activities and investment “recommendations” that previously were not regarded as investment advice will now be treated as such. In the context of private fund investments, the final rule affects common marketing and other related activities involving ERISA plan and/or individual retirement account (IRA) investors, prospective investors, clients and/or prospective clients. Anyone that engages in these activities will be considered advice fiduciaries of the retirement plan investors. The rule was intended to increase safeguards for retail IRA investors, with the focus towards establishing fiduciary obligations on brokers and other advisors not previously subject to ERISA. However, it is highly uncertain whether, and to what extent, the fiduciary rule would apply to private funds, such as private equity sponsors or hedge fund managers.
In general, private fund managers do not offer fiduciary investment advice, as they do not advise retirement plan investors on how to invest. Whereas, they traditionally manage pooled assets from multiple investors, which may or may not include retirement investors. The new rule limits the definition of “recommendation” to communications to a specific advice recipient regarding the advisability of a particular investment or management decision.
Based on the way private funds are structured, they should not be subject to these new fiduciary rules when making investment decisions on behalf of the fund. Private funds were likely not the intended target of these new rules, however, they could get pulled into the framework of the rules under certain circumstances, particularly for IRA investors. Private funds could avoid the rules by meeting at least one of two ERISA exceptions: (i) The Venture Capital Operating Company Exemption (the “VCOC”), or (ii) the 25% percent rule.
Both ERISA exceptions are complicated, but generally, under VCOC, an investment vehicle that holds at least 50 percent of assets invested in operating companies does not hold plan assets and if the retirement plan assets represent less than 25% of the fund equity, the funds is not treated as holding plan assets under ERISA. If the fund meets one of these exceptions, then it would be deemed to not hold plan assets and the new fiduciary rules should not be triggered. However, the new fiduciary rules created some uncertainly as to the application of the fiduciary rules for private funds to potential investors prior to the completion of the fund raising transaction.
For private funds, satisfying one of the two ERISA exemptions should limit their exposure to the new fiduciary rules once the fund has already been launched. However, the majority of all marketing for private funds occur prior to the fund raising closing. The application of the new fiduciary rules to the marketing of a new private fund is still quite unclear. As a result, the DOJ expanded the definition of the so called “seller’s exception,” also known as the “expert fiduciary exclusion,” which was designed to exempt recommendations and materials provided to independent fiduciaries with financial expertise.
In order to take advantage of this exception, the potential investor must be an independent fiduciary with financial expertise, which would include (a) a bank, (b), an insurance company, (c) an entity registered as an investment adviser under the Investment Advisers Act of 1940 or registered as an investment adviser with the state in which it has its principal office, (d) a broker-dealer registered with the SEC, or (e) an independent fiduciary that holds, or has under management or control, at least $50 million.
In addition, the person providing the “recommendation” must reasonably believe that the independent fiduciary is capable of evaluating investment risks independently and must also inform the fiduciary that it is not providing impartial advice and may have an interest in the transaction. Furthermore, the service provider must not receive a fee or other compensation directly from the plan, plan fiduciary, plan participant, IRA or IRA owner for the provision of investment advice, as opposed to receiving an indirect fee for acting as investment manager to a private fund in which the plan invests.
The “seller’s exception,” basically puts the responsibility on the fund manager to confirm that marketing materials are only offered to individuals who qualify under this exception. The issue with self-directed retirement investors, such as a self-directed IRA or 401(k) qualified plan, seeking to make a private fund investment, is that it is impossible to satisfy the “seller’s exemption” without hiring an independent fiduciary, which seems unnecessary if the purpose of using a self-directed retirement account is to direct your own investments. This is not a situation where a retail investor is seeking the advice or recommendation of an investment advisor. In fact, most traditional banks and financial institutions will not allow retirement account holders to make alternative asset investments, such as private fund investments. Hence, the retirement account holder is generally required to establish a self-directed IRA with a non-fiduciary IRA custodian.
Because many private fund managers are seeking to protect themselves from the application of the new fiduciary rules by forcing the retirement account investor to satisfy the “seller’s exemption, the result is the self-directed IRA investor is being obligated to hire an independent fiduciary to make the private fund investment or, in some cases, not permitted to invest at all. The independent fiduciary would then be required to satisfy the new fiduciary rules or seek an exemption, under, for example, the “best interest contract”. As a result, the retirement account investor is being forced to incur delays and potential costs in order to allow the private fund manager to side step the new fiduciary rules, which were likely never intended to govern this type of investment relationship in the first place.
The new fiduciary rules was designed to offer retail IRA investors a higher level of financial advisory services, but the impact of the new rules on IRA investors seeking to make private fund investments is something the DOL will likely need to address.