For private fund managers, fiduciary rule rollback means qualified assets welcome again

For much of the market for private investment funds, the Labor Department’s fiduciary rule was a non-issue.

The world of private equity and hedge funds is mostly the domain of defined benefit plans, endowments, and other institutional investors, the majority of which hold assets above $50 million, qualifying them for the “sellers carve out” in the rule.

But for a smaller portion of the private fund market that sells investments to qualified or accredited investors—high net-worth investors in the retail market—the controversial fiduciary rule, which was partially implemented a year ago and has since been vacated by a federal court, had the effect of stifling investments from qualified retirement accounts.

“For the vast majority of our clients, the rule had zero impact,” said S. John Ryan, a partner in Seward & Kissel’s employee benefits group practice. “But our concern was that fund managers’ communications to individual investors would amount to advice under the rule.”

Provisions of the Investment Company Act of 1940 give managers of private funds some latitude based on the financial sophistication of accredited investors—those with at least $1 million in new worth or $200,000 in annual income—and qualified investors—those with assets in excess of $5 million.

Ryan calls them the “Mitt Romney” of the retail market.

“Mitt Romney is expected he will do his due diligence when investing in a private fund,” explained Ryan. “But, under the rule, if he doesn’t hire an independent fiduciary advisor, then that would make offering the fund a fiduciary act. We could not see how you would get around that.”

Garden-variety retail retirement investor vs. high net worth investors

For the private fund market, the upshot of the rule was real, said Ryan. Nearly all—“99 percent”—of his firm’s private fund clients would not accept investments from IRAs or small plans with less than $50 million in assets unless those investors could represent they had their own independent fiduciary advisors.

In trying to protect the garden-variety retail retirement investor, the rule swept in those investors the SEC has distinguished based on net worth.

“The DOL was so worried about what was happening in the larger retail market—they were truly concerned with how people were making sales pitches to Grandma’s IRA,” said Ryan.

But for qualified and accredited investors, the rule’s expanded definition of advice gave protections where they were not needed, creating the unintended consequence of erecting potential barriers to private funds.

“Under the ordinary concept of what investment advice is, it’s hard to understand how offering a hedge fund to an investor would be seen as a fiduciary act. You are not advising them to invest in the fund, you are simply offering it,” said Ryan.

The question is somewhat academic. The rule has been officially vacated in the U.S. Court of Appeals for the Fifth Circuit. The District Court for the Northern District of Texas has set a deadline for today—July 12—for parties to request further relief. California, New York, and Oregon were denied previous bids to intervene to defend the rule.

It is possible they will request a rehearing of the case by the end of today. If that request is not made, the case will officially be closed.

Reexamine language in fund and client communications

The work now for private fund managers is to reexamine language written into fund prospectuses and client communications to account for the fiduciary rule.

Ryan is recommending his clients remove language that accounted for the fiduciary rule from fund and client communications, a straightforward process he says can be done quickly.

Even as the rule has been vacated, there has been speculation that some in industry may keep the rule’s Impartial Conduct Standards in place and use its best interest standard requirement for a competitive toehold.

Doing so could inadvertently backfire on fund managers, said Ryan.

“If you say you are a fiduciary in writing, then that means there are prohibited transactions. But without the rule, there is no (Best Interest Contract) exemption. Engaging in a prohibited transaction without an exemption is problematic,” said Ryan.

Ryan does not believe that mangers of private funds will face brand or reputation risk in removing fiduciary language from communications with investors.

“There’s a small group of funds who said contractually they are fiduciaries. Now they need to make a decision: do they go back to their clients and say they are no longer fiduciaries, or do they decide to manage their business in a way that would comply with the rule,” explained Ryan.

The greater risk is in the latter option, thinks Ryan.

If managers choose to withdraw their fiduciary pledge, he expects little, if any blow back from investors. “I don’t think investors in private funds ever believed the person selling the investment—the fund manager—was a fiduciary. And I don’t believe these investors would be shocked if a manager said, when offering a fund, that they are not acting as a fiduciary. I don’t think there will be much push back.”

Of course, communications with investors in private funds may again need to be amended in the foreseeable future, as the SEC promulgates its set of selling standards for broker-dealers.

Whether that rule sweeps private funds into the fold will depend on how “surgically” the SEC defines the retail investor market.

“I am hoping they will distinguish Mitt Romney from Grandma,” said Ryan. “If that’s the case, there shouldn’t be implications for investors in the private fund market.”