This is the third of three articles in a series intended to acquaint – or reacquaint – hedge fund managers, investors, service providers and others with the basic principles and prohibitions of, and exemptions from, the Employee Retirement Income Security Act of 1974 (ERISA). The first article in this series explained how hedge fund managers can become – or avoid becoming – subject to ERISA. That article focused primarily on the “25 percent test,” which generally provides that if benefit plan investors (e.g., corporate pension funds) own less than 25 percent of any class of equity interests issued by a hedge fund, the hedge fund manager will not be subject to ERISA. See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part One of Three)
,” Hedge Fund Law Report, Vol. 3, No. 19 (May 14, 2010). The second article in the series detailed the consequences to a hedge fund manager of becoming subject to ERISA, which can happen, for example, if a large non-ERISA investor redeems, causing the proportionate ownership of benefit plan investors to exceed 25 percent of a class of equity interests. Those consequences most notably include the imposition of a heightened fiduciary duty and a prohibition on many transactions between the hedge fund and “parties in interest” to a benefit plan invested in the hedge fund. See “How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA’s More Onerous Prohibited Transaction Provisions? (Part Two of Three)
,” Hedge Fund Law Report, Vol. 3, No. 20 (May 21, 2010). As that second article noted, ERISA’s list of prohibited transactions is so long, and ERISA’s definition of “party in interest” (and the parallel definition of “disqualified person” under the Internal Revenue Code) so expansive, that strict compliance by investment managers with ERISA’s prohibited transaction provisions would undermine the basic purpose of ERISA; broadly, that purpose is to ensure the ethical, unconflicted and competent management of retiree money. Accordingly, Congress (by statute) and the Department of Labor (by regulation and other action) have created a series of exemptions from the prohibited transaction provisions. These exemptions enable a hedge fund to accept investments from benefit plan investors above the 25 percent threshold and
to engage in many transactions that otherwise would be prohibited by ERISA. That is, many hedge fund managers heretofore have taken the view that a fund can have significant ERISA money or a manager can have unfettered investment discretion, but not both. But the prohibited transaction exemptions, properly understood and implemented, come close to reconciling that dichotomy. To assist hedge fund managers in obtaining ERISA assets while retaining investment discretion, this article provides a comprehensive roadmap to the prohibited transaction exemptions most relevant to hedge fund managers. Specifically, this article discusses: ERISA’s definition of “party in interest”; prohibited transactions under ERISA by category; typical hedge fund transactions that would (absent statutory and regulatory relief) be prohibited by ERISA; the conditions required to be satisfied for a hedge fund manager to qualify as a qualified professional asset manager (QPAM); the impact of the financial regulation overhaul bills on hedge fund managers’ eligibility for the QPAM exemption; the conditions required to be satisfied for a transaction to be eligible for the QPAM exemption; the impact of ERISA’s anti-self-dealing provisions on the timing of disposition of investments in private equity funds and hybrid funds; the service provider exemption; the eleven conditions that must be satisfied for performance compensation to comply with ERISA; the cross trading exemption; the foreign exchange transaction exemption; the electronic communication networks exemption; the block trading exemption; individual exemptions, including a discussion of a recent individual exemption granted to Ivy Asset Management Corporation in connection with a proposed sale of shares of offshore hedge funds owned by a hedge fund of funds; and a provocative provision included in the Restoring American Financial Stability Act of 2010, passed by the U.S. Senate on May 20, 2010, that threatens to undermine the ability of certain hedge funds to enter into swaps with prime brokers.