This is the second article in a three-part series of articles we are doing on ERISA considerations in the hedge fund context. Specifically, the first article in this series dealt with how hedge funds and their managers can become − and avoid becoming − 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). This article deals with the consequences to hedge funds and their managers of becoming subject to ERISA. And the third article will detail strategies for accepting investments from "benefit plan investors" above 25 percent of any class of equity interests issued by a hedge fund while avoiding many of the more onerous prohibited transaction provisions and other restrictions imposed by ERISA. In short, the structure of this series is: application, implications, avoidance. As explained in the first article, the occasion for this series is the gulf between forecasts and experience with respect to inflows into hedge funds globally. Forecasts suggest that the rate of new investments into hedge funds should be increasing, but experience suggests that fundraising remains a primary challenge for many hedge fund managers, even seasoned managers with good track records. We think that one explanation for this gulf may involve the nature of the anticipated new assets: many of those assets are likely to come from U.S. corporate pension funds. Such investors generally employ a long and conscientious pre-investment due diligence process, or from the hedge fund perspective, involve a longer sales cycle. But when they invest, they invest for the long term. That is, we think those new assets are out there, and are moving slowly and carefully into hedge funds, focusing on a wider range of considerations when allocating capital, including considerations beyond track record such as transparency, liquidity, risk controls, regulatory savvy and other "non-investment" criteria. (Most hedge fund blowups have been the result of operational rather than investment failures.) U.S. corporate pension funds are the quintessential ERISA investor. Therefore, when competing for allocations from U.S. corporate pension funds, facility with the contours of ERISA (it's an infamously byzantine statute) will be a competitive advantage for hedge fund managers. The purpose of this series of articles is to help hedge fund managers hone that competitive advantage. If a hedge fund comes within the jurisdiction of ERISA, the hedge fund and its manager become subject to a series of new obligations and limitations that otherwise would not apply. Most notably on the obligations side, the manager becomes subject to a more particularized fiduciary duty standard than is imposed by the Investment Advisers Act or Delaware law. And most notably on the limitations side, the hedge fund (which is deemed to constitute "plan assets" for ERISA purposes) is prohibited from engaging in a series of transactions with so-called "parties in interest." This article explains the ERISA-specific fiduciary duty, as well as ERISA's per se prohibited transactions, in greater detail. In addition, on the obligations side, this article details the unique ERISA reporting regime, focusing on the Department of Labor's (DOL) Form 5500 Schedule C (including a discussion of reporting requirements with respect to direct compensation, indirect compensation, eligible indirect compensation and gifts and entertainment); and custody and bonding requirements. And on the limitations side, this article discusses, in addition to prohibited transactions, limitations imposed on hedge funds and managers with respect to: performance fees; cross trades; principal trades; soft dollars; affiliated brokers; securities issued by the employer who sponsors the relevant ERISA plan; expense pass-throughs; indemnification and exculpation; and placement or finders' fees (and related "pay to play" considerations). Finally, this article discusses the broad reach of liability and the penalties that may be imposed for violations of ERISA's obligations or limitations, and the cure provisions available for certain breaches. While this article outlines a seemingly oppressive set of consequences flowing from application of ERISA to a hedge fund and manager, it should be noted that the third article in this series will strike a considerably more optimistic note. The list of prohibited transactions under ERISA is so long, and the definition of party in interest so broad, that literal compliance with ERISA would actually run contrary to the intent of ERISA, which is to protect retiree money. That is, a hedge fund manager or other investment manager forced to comply with all of the investment and operational prohibitions of ERISA would not be able to effectively serve the interests of benefit plan investors. Recognizing this, the DOL has promulgated an extensive series of "class exemptions" that provide relief from the prohibited transaction and other provisions of ERISA, and the DOL from time to time also provides individual exemptions (similar to the SEC's no-action letter process). Those categories of relief will be the subject of the third article in this series.