Seward & Kissel LLP and our alliance partner, Simmons & Simmons have received inquiries regarding whether the imposition by the Alternative Investment Fund Managers Directive’s (the “Directive”) imposition of valuation responsibilities on an alternative investment fund manager (the “AIFM”) is incompatible with the rules and guidance under the U.S. Employee Retirement Income Security Act of 1974, as amended (“ERISA”), relating to the receipt of incentive or performance based fees or allocations by a manager acting as an ERISA fiduciary1. For the reasons set forth below, we do not believe that an AIFM’s valuation responsibilities conflict with the applicable ERISA guidance, although some additional steps may be required in relation to “Level 3” assets.
Article 19 of the Directive describes the obligations of an AIFM in respect of valuing the assets of an Alternative Investment Fund (an “AIF”). The relevant provisions of that Article are implemented in the U.K. by the Financial Conduct Authority (“FCA”) in the rules in FUND 3.9 of the FCA Rulebook. Of particular significance is that these rules provide that:
(a) the AIFM is responsible for the valuation of an AIF’s assets; and
(b) the valuation function2 must be performed by the AIFM unless an external valuer is appointed.
Under U.S. Department of Labor (“DOL”) guidance regarding the payment of incentive-or performance-based compensation by plans, the valuation of the assets managed by a fiduciary must be based on market quotations or independent sources. As explained by the DOL in its guidance, the self-dealing prohibitions of ERISA are imposed upon fiduciaries to deter them from exercising the authority, control, or responsibility which makes them fiduciaries when they have interests that may conflict with the interests of the plans for which they act, and in the context of incentive- or performance-based compensation operate to prevent a fiduciary from controlling the amount or timing of such compensation. Thus, a fiduciary may not use the authority, control, or responsibility which makes him a fiduciary to cause a plan to pay an additional fee to such fiduciary. However, a fiduciary does not engage in an act prohibited by ERISA’s self-dealing rules if the fiduciary does not use any of the authority, control, or responsibility that makes him a fiduciary to cause a plan to pay additional fees for a service furnished by such fiduciary.
The DOL concluded that the payment of an incentive fee pursuant to an arrangement that takes into account both realized and unrealized gains and losses during a pre-established valuation period and that is based upon investments in securities for which market quotations are readily available or upon an independent valuation of securities for which market quotations are not readily available would not, in itself, constitute a violation of ERISA’s self-dealing prohibitions. The DOL determined that, in those circumstances, the amount of compensation that the investment manager could earn depends solely on the changes in value of the securities in the individual account or limited partnership, as determined by readily available market quotations or independent appraisals and therefore, the investment manager would not be exercising any of its fiduciary authority or control to cause a plan to pay an additional fee. In reaching its conclusions, the DOL noted that the issues of whether a person is independent of an investment manager and what constitutes an independent valuation are factual questions to be resolved on the basis of all the surrounding facts and circumstances.
It is our view that, the DOL’s guidance does not impose a per-se ban on performance-based compensation merely because an AIFM is responsible for the valuation function mandated by the Directive. However, an AIFM that is managing a plan asset AIF must examine the facts and circumstances surrounding the AIF’s assets and the AIFM’s valuation methodology and determine that the AIFM is not using the authority which makes it an ERISA fiduciary to cause the AIF to pay a fee that is based on changes in value of the securities in the AIF that are not determined by readily available market quotations or independent pricing sources. While this examination must be conducted by each plan asset AIFM and its counsel, there are three general categories of plan asset AIFs that present different levels of complexity.
First, there are master-feeder fund structures where the feeder fund (the “Feeder”) is a plan asset fund but the master fund (the “Master”) is required to remain below ERISA’s 25% threshold. In this case, the assets of the Feeder are its interests in the Master (the “Master Shares”). Provided that the Feeder’s offering documents (and the AIFM’s valuation policy) require that the Feeder accept the Master’s NAV in determining the value of the Master Shares, the AIFM, as investment manager and ERISA fiduciary to the Feeder, will not be using the authority, control, or responsibility that makes it an ERISA fiduciary to cause the Feeder to pay an additional fee to the AIFM. This type of arrangement is therefore consistent with the DOL’s guidance.
Second, there are stand-alone funds and master funds that are plan assets funds, but which only invest in Level 1 or Level 2 assets. Provided that the AIFM’s valuation policy is specific as to the sources and hierarchies of the inputs used in valuing the fund’s assets, the amount of compensation which the AIFM could earn depends solely on the changes in value of the assets, as determined by readily available market quotations or indirectly through the use of observable independent data. This type of arrangement is also consistent with the DOL’s guidance.
Finally, there are stand-alone and master funds that are plan assets funds that also invest in Level 3 assets. The AIFM to these funds will need to review the types of assets that these plan asset AIFMs may hold and develop valuation policies and procedures that require that all values are determined by readily available market quotations or based on independent pricing sources in order to be consistent with the DOL’s guidance. This may require the value to be used for Level 3 assets to be determined by an independent third party. An independent third party for this purpose could include the administrator3, the independent directors of the AIF or a third party valuation agent.
This client alert examines Article 19 of the Directive as implemented in the UK; other EU jurisdictions may implement Article 19 in a different manner. Additionally, this client alert may be considered attorney marketing and/or advertising. Prior results do not guarantee a similar outcome. The information contained in this e-mail is for informational purposes only and is not intended and should not be considered to be legal advice on any subject matter. As such, recipients of this e-mail, whether clients or otherwise, should not act or refrain from acting on the basis of any information included in this e-mail without seeking appropriate legal or other professional advice. This information is presented without any warranty or representation as to its accuracy or completeness, or whether it reflects the most current legal developments.
If you have any questions or comments, please contact S. John Ryan at (212) 574-1679 or ryans@sewkis.com, or Richard Perry at +44 20 7825 4310 or richard.perry@simmons-simmons.com.
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1 Generally, the investment manager of an AIF becomes an ERISA fiduciary if 25% or more of any one class of equity interests of the AIF are held by U.S. pension plans and other “Benefit Plan Investors”.
2 Note that, for these purposes, the “valuation function” is generally understood to mean the function of valuing the assets, excluding the function of calculating NAV.
3 In practice, it is uncommon for fund administrators to accept appointments as external valuer for “Level 3” assets, even if that administrator will accept such appointments for “Level 1” and “Level 2” assets.
