The Department of Labor’s New Fiduciary Rule: Frequently Asked Questions for Private Fund Advisers
Core elements of the U.S. Department of Labor’s controversial new fiduciary investment advice rule (the “Fiduciary Rule”) became effective on June 9, 2017, despite President Trump’s February 3, 2017 memorandum ordering further review of the rule, and despite numerous attempts in Congress and in the courts to halt its adoption.
Most of the debate over the Fiduciary Rule has focused on its impact on broker-dealers. However, the rule is also likely to have a significant impact on investment advisers, particularly those who act as advisers to private investment funds.
While the future of the Fiduciary Rule remains uncertain, and though some elements of the rule will not become effective until January 1, 2018 or later, the elements of the rule that are now effective will require that many advisers make fundamental changes to the manner in which they interact with certain types of investors.
The purpose of this FAQ is to provide an overview of certain key components of the Fiduciary Rule as they relate to private fund advisers.
What is the Fiduciary Rule?
The Fiduciary Rule is a new regulation issued by the U.S. Department of Labor (“DOL”) that dramatically expands the types of communications that may be considered “investment advice” and the circumstances under which furnishing investment advice to an employee benefit plan subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), or an individual retirement account (“IRA”) will cause the provider of advice to be considered a fiduciary under ERISA or to be subject to the prohibited transaction rules under ERISA or the Internal Revenue Code of 1986, as amended (the “Code”).
The Fiduciary Rule is designed in part to address conflicts of interest that could lead advisers to recommend high-fee investments that potentially harm retirees. It is targeted primarily at broker-dealers, who were not previously subject to fiduciary obligations. However, due to the broad definition of “investment advice,” the rule is also likely to have a significant impact on certain investment advisers to private equity funds and hedge funds.
Under what circumstances will the Fiduciary Rule apply to private investment fund advisers?
Under the Fiduciary Rule, “investment advice” includes, among other things, recommendations with regard to the purchase, sale and management of investments. As such, the rule will apply to an adviser when it makes an investment “recommendation” to an IRA or ERISA plan if the adviser directly or indirectly receives any fee or other compensation from any source in connection with or as a result of that recommendation.
The management fees, carried interest and incentive allocations traditionally received by advisers for managing private funds constitute compensation for purposes of the foregoing. As a result, the applicability of the Fiduciary Rule will hinge primarily on whether the adviser has made a “recommendation” to an IRA or ERISA plan.
What is a recommendation?
The 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.”
Due to the breadth of this definition, a fund adviser may become subject to the rule in the course of marketing a private fund to an IRA or ERISA plan investor or in connection with an IRA or ERISA plan investor’s decision to invest in, retain or increase an existing investment in, or to withdraw capital from, a private fund.
The preamble to the Fiduciary Rule explains that an adviser marketing itself to an ERISA plan or IRA, without a recommendation to invest, should not alone constitute investment advice. However, when a so-called “hire me” recommendation is coupled with a recommendation as to how an ERISA plan or IRA should invest, such as a recommendation to invest in a specific investment or fund, that recommendation would need to be evaluated separately under the rule to determine whether it constitutes “investment advice.”
The Fiduciary Rule provides that an adviser does not make a recommendation merely by disseminating general communications, such as marketing or offering materials, prospectuses, performance reports and other information for general audiences. However, where an adviser recommends that an ERISA plan or IRA invest in a particular fund or series of a fund, discourages a withdrawal or reallocation of funds, recommends a particular investment amount or provides other advice tailored to the specific needs of an ERISA plan or IRA investor, it may be deemed to have made a recommendation that constitutes “investment advice.” Due to the nature of the DOL’s guidance in this respect, many private fund advisers will face substantial uncertainty as to whether certain meetings and communications with prospective ERISA plan and IRA investors during a fund marketing process may constitute recommendations that give rise to fiduciary status.
What happens if an adviser makes a recommendation in the course of marketing a fund?
If an adviser becomes subject to the Fiduciary Rule in connection with its marketing activities and does not satisfy an exception or qualify for other relief, it may risk violating certain prohibited transaction rules under ERISA and the Code that are intended to prohibit a fiduciary from advising an ERISA plan or IRA to engage in transactions that result in the payment of additional consideration to the fiduciary or its affiliates.
What if the fund qualifies as a VCOC or REOC?
Advisers to private funds that are deemed hold ERISA plan or IRA assets may be impacted to the same extent as other advisers if they make recommendations in connection with their marketing activities. However, the Fiduciary Rule generally should not otherwise impact such advisers’ fiduciary obligations with respect to such plan asset funds.
Advisers to funds whose assets are not deemed to be plan assets – due to the funds’ qualification as venture capital operating companies (VCOCs), real estate operating companies (REOCs) or satisfaction of the 25% “significant participation” test – may become fiduciaries under the Fiduciary Rule to the extent they make recommendations in connection with their marketing activities. However, the application of the Fiduciary Rule alone should not cause such advisers to become fiduciaries with respect to the management of plan assets at the fund level.
What options does a private fund adviser have?
One option is to limit all communications with ERISA plan and IRA investors to those general communications that are clearly not recommendations (e.g., the distribution of marketing materials for general prospective investor audiences). An adviser that pursues this approach should consider providing in its offering materials that it does not make recommendations with respect to investments in the fund and incorporating into its internal compliance manuals guidance designed to avoid communications that might be deemed recommendations.
Private fund advisers who communicate frequently (especially on a one-on-one basis) with their investors or who provide investment advice that is tailored to particular investors may find it difficult or impossible to take the position that they are not providing recommendations in connection with their marketing activities. In such cases, it may be necessary to rely on the independent fiduciary safe harbor of the Fiduciary Rule.
What is the Independent Fiduciary Safe Harbor?
The Fiduciary Rule provides a safe harbor for recommendations made to an independent fiduciary of an ERISA plan or IRA who meets certain financial sophistication requirements. In order to rely on this safe harbor, a fund adviser will be required to satisfy the following conditions (possibly by including appropriate provisions in the relevant subscription documents):
- The fiduciary is independent of the fund adviser making a recommendation to it (meaning the fiduciary has no financial interest in or other relationship to the fund adviser that may conflict with the interests of the ERISA plan or IRA investor for which it acts or may otherwise affect its best judgment as a fiduciary);
- The fund adviser knows or reasonably believes that:
- the independent fiduciary is:
- a bank subject to U.S. federal or state regulation;
- an insurance company qualified under a state’s law to manage plan assets;
- a registered investment adviser under the Investment Advisers Act of 1940, as amended;
- a broker-dealer registered under the Securities Exchange Act of 1934, as amended; or
- any other independent fiduciary with total assets under management of at least $50 million (such as the investment committee of an ERISA plan, though the size of the particular ERISA plan investor is not relevant as long as the committee that controls the investment of the ERISA plan’s assets meets the $50 million test).
- the independent fiduciary is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies; and
- the independent fiduciary is a fiduciary under ERISA or the Code or both, with respect to the transaction and is responsible for exercising independent judgment in evaluating the transaction (though the independent fiduciary need not have discretionary authority with respect to the transaction);
- The fund adviser fairly informs the independent fiduciary that it is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity, in connection with the transaction and fairly informs the independent fiduciary of the existence and nature of the fund adviser’s financial interests; and
- The fund adviser does not receive a fee or other compensation directly from the ERISA plan or IRA investor or independent fiduciary for the provision of investment advice in connection with the transaction. This condition should not be violated by the mere fact that the private fund pays its adviser a management fee, carried interest or other incentive compensation.
The DOL has indicated that an ERISA plan representative or IRA account holder may attend a meeting at which the private fund adviser makes a presentation. However, because the adviser must know or reasonably believe that the independent fiduciary is making a recommendation in its fiduciary capacity in order for the independent fiduciary safe harbor to be available, fund advisers should consider requiring that the independent fiduciary be present at all such meetings and that all communications be directed to the independent fiduciary or, if to the ERISA plan representative or IRA account holder, with the independent fiduciary’s prior review and approval.
Importantly, the independent fiduciary safe harbor does not cover advice provided to an IRA owner with respect his or her own IRA, even where the IRA owner would be considered a sophisticated investor for purposes of securities laws and has $50 million or more in assets. Accordingly, advisers who market private funds to IRA investors and wish to avail themselves of the independent fiduciary safe harbor should adopt policies requiring such investors to be represented by third-party independent fiduciaries.
What other options are available?
In cases where an adviser is able neither to limit its communications to fit within the “hire me” or general communications constructs described above, nor to comply with the requirements of the independent fiduciary safe harbor with respect to certain categories of investors (e.g., IRA investors who are not represented by third-party independent fiduciaries), the adviser may wish to suspend new investments by those categories of investors.
If an adviser continues to accept investors who do not qualify under the independent fiduciary safe harbor and does not limit its communications as described above, it may become a fiduciary under ERISA and/or the Code and, as a result, would be required to comply with the Impartial Conduct Standards (“ICS”) under the Fiduciary Rule’s Best Interest Contract Exemption (the “BIC Exemption”) (and, after January 1, 2018, with certain other requirements of the BIC Exemption). A discussion of the ICS and BIC Exemption is beyond the scope of this FAQ.
How did we get here?
The history of the Fiduciary Rule is long and fraught with conflict. An early version of the rule was first introduced in 2010 and was subsequently withdrawn amid widespread criticism. A new version was introduced in 2015. After a period of public comment and hearings, it was released in final form on April 8, 2016.
On February 3, 2017, President Trump issued a memorandum seeking further review of the Fiduciary Rule and questioning whether the rule “is likely to harm investors due to a reduction of Americans’ access to certain retirement savings offerings, retirement product structures, retirement savings information, or related financial advice.” The memorandum prompted the DOL to delay its implementation until June 9, 2017. While many commentators expected further delays, DOL Secretary Alexander Acosta announced on May 22, 2017 that, despite President Trump’s memorandum, there was no legal justification for a further delay in implementation. The core elements of the rule went into effect on June 9, 2017.
What happens next?
The DOL has issued a temporary enforcement policy providing that, until January 1, 2018, it will not take any enforcement action against persons who are working diligently and in good faith to comply with the Fiduciary Rule and applicable exemptions. During that transition period, Secretary Acosta has indicated that the DOL will continue its evaluation of the Fiduciary Rule, as directed by President Trump’s memorandum, and may consider changes to the rule and possible further extensions to the transition period.
Separately, on June 1, 2017, U.S. Securities and Exchange Commission (“SEC”) Chairman Jay Clayton issued a statement indicating that the SEC intends to “engage constructively” with the DOL in analyzing the appropriate standards of conduct applicable to different types of professionals who provide advice to retail investors. In his statement, Chairman Clayton noted that the DOL’s Fiduciary Rule “may have significant effects on retail investors and entities regulated by the SEC. It also may have broader effects on our capital markets. Many of these matters fall within the SEC’s mission of protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation.” It is possible that coordination between the SEC and DOL could result in harmonization of their respective regulatory regimes applicable to investment advisers and broker-dealers.
Meanwhile, on June 8, 2017, the U.S. House of Representatives passed the Financial Choice Act, which, if enacted into law, would effectively override the Fiduciary Rule, in addition to overhauling elements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. While the Financial Choice Act’s prospects in the U.S. Senate are uncertain, additional legislation aimed at halting and replacing the Fiduciary Rule has been introduced in both the House and the Senate and may be considered in parallel with the Financial Choice Act.
Though the future of the Fiduciary Rule remains to be seen, private fund advisers should be mindful of the provisions of the rule that are now in effect and should consider how their existing practices and fund documentation fit within the new regulatory framework. Given the complexity of the Fiduciary Rule, and the rapidly evolving DOL and SEC guidance in connection therewith, it will be critical for advisers to consult with their attorneys and compliance professionals as they work to navigate the new regulations.
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