Occasionally, we will receive a reader question that requires a little digging into. When we get one like this, we feel like we should put it up for all to see.
Question from Steve: We have a client who is the CFO of a Hedge Fund company. 100% of their employer match is being automatically put into their own hedge
fund. We believe that this presents a real fiduciary risk for our client, but I was hoping you could
site a lawsuit or DOL guidance?
Our Response: Steve, there are several situations
that I think apply to this directly, and specifically with regard to hedge funds. The first issue is a recent case, Sulyma vs. Intel; reference article here Former Employee Sues Intel Over Hedge Fund. This lawsuit is ongoing and only alleges
imprudent investing in hedge funds meaning that it does not allege a conflict
of interest which would be a violation of duty of loyalty to the participants (ERISA §404(a)). I believe your group would
have both the imprudent investing problem as well as a conflict
of interest; a possible Self-Dealing violation of ERISA §406(b). So they would
be potentially violating two sections of ERISA §404(a) and have a non-exempt
Prohibited Transaction under §406(b)(2).
ERISA § 404(a)(1)
to act solely in the interest of the participants and beneficiaries of the
plans they serve and “(A) for the exclusive purpose of: (i) providing benefits
to participants and their beneficiaries; and (ii) defraying reasonable expenses
of administering the plan” and (B) to discharge their duties “with the care,
skill, prudence, and diligence under the circumstances then prevailing that a
prudent man acting in a like capacity and familiar with such matters would use
in the conduct of an enterprise of a like character and with like aims.”
In the Intel lawsuit it almost
implies that a plan can never invest outside of the current norm (Modern Portfolio Theory, “normal” asset
classes, etc.). So the question is: “How does innovation occur in the prudent world
of ERISA plans?” This is something the industry will have to address at some point.
I also wanted to dig into
whether or not there would/could be a Prohibited Transaction Exemption (PTE) for this. For
example, there are PTEs for mutual fund companies selecting their own funds for
their employees 401(k) Plan. Actually
American Express tried to cite this PTE when they were sued a few years
ago by their employees and when ruled they didn't meet the PTE, Amex
settled the case for $15m. Not to be too technical here but I don't think
many of the PT exemptions (listed below) are going to be available to this
group. As mentioned, there is, in fact, a DOL opinion that deals with
mutual funds, but, because the hedge fund is specifically not a
registered investment company under the Investment Company Act of 1940, I
believe they have much less room to act.
The potential conflicts of interest
that could arise are numerous. Here’s just a few. Are they
receiving any fees? Are the plan assets giving them some kind of economy of
scale? Are the plan assets used as seed money for a new fund? Here is
full piece on the matter published by Groom Law Group, but the excerpt I
clipped out below is what’s applicable. See the yellow highlighted area.
Investing Plan Assets in
Proprietary Mutual Funds. To the extent that a plan fiduciary also serves as
investment adviser to a registered, open-end investment company, the
fiduciary’s investment of plan assets in the mutual fund may involve one or
more fiduciary conflicts. PTE 77-4 (for client plans) and PTE 77-3 (for the
fiduciary’s own, in-house, plans) provide relief for such investments provided
that certain conditions are satisfied, including disclosure and consent, and
taking steps to avoid double fees. Similar relief is granted under PTE 79-13
for in-house plans of closed-end investment companies (but not for client plans, which effectively prevents most
registered hedge fund managers from relying on these exemptions).
PTE 84-24 also exempts, among other things, a plan’s investment in a mutual
fund where the fund’s adviser or principal underwriter is also a directed
trustee, prototype plan sponsor, or other service provider with respect to a
plan (but not a discretionary investment manager or trustee, nor the plan
sponsor), where an
affiliate of the fund’s adviser or principal
underwriter will receive a sales commission with respect to the transaction.
For this purpose, sales commissions generally include 12b-1 distribution fees.
The PTE does not explicitly authorize the receipt of fund-level advisory and
other fees (in contrast to PTEs 77-3 and 77-4), though it appears to do so
implicitly. (Note that PTE 84-24 is not limited to the marketing of proprietary
funds, though it is often used for that purpose.)
Steve, thank you for the excellent question and the chance to flex our research muscles.
- Jason Grantz
No comments:
Post a Comment