Pension managers investing in the hedge fund hybrid known as a fund of funds would do well to take a close look at their contract wording to ensure they are not in violation of ERISA, an industry expert says.
Hedge funds, including funds of funds, have become popular in the past four years as institutional investors look for alternatives to the traditional stocks and bonds. Experts estimate that there are now some 7,000 hedge funds representing from $750 billion to $1 trillion in assets that are growing daily.
Pension plans are among the investors that have found hedge funds attractive; in fact, they represent the largest growing demographic investing in hedge funds, with an increase of 453%, from $13 billion in Jan. 1997 to $72 billion in 2004, according to the Hennessee Hedge Fund Advisory Group's 10th Annual Hennessee Hedge Fund Manager Survey.
Funds of funds, which combine shares of hedge funds and private-equity funds, are the fastest-growing source of capital for hedge funds, increasing 810% since Jan. 1997, from $21 billion to $191 billion, the Hennessee Group reports. Because they represent an array of hedge funds, this diversity attracts many investors, including pension plans.
But Charles Gradante, managing principal and CIO with the Hennessee Hedge Fund Advisory Group, questions whether pension plans are violating the Employee Retirement Income Security Act of 1974 when they sign an agreement with a fund of funds, particularly the publicly offered ones.
Among other rights, ERISA gives participants the right to sue for benefits and breaches of fiduciary duty. But, "pension plans should consider that they give up their rights with funds of funds," Gradante says.
Gradante offers as proof this direct quote from a typical fund of funds agreement: "Investors in the fund [fund of funds] have no individual right to receive information about the investment funds [hedge funds] or the investment managers [hedge fund managers], will not be investors in the investment funds and will have no rights with respect to or standing or recourse against the investment fund, investment managers, or any of their agents."
While such an agreement may be worded slightly differently among funds of funds contracts, Gradante says that the basic notion is consistent in all funds of funds agreements.
Gradante points to the prudent investor rule in ERISA and the Uniform Prudent Investor Act, which cite a fiduciary's duty to delegate, which in turn "imposes two key responsibilities that present risks to trust fiduciaries when using a publicly offered fund of hedge funds: the duty of due diligence and the duty to monitor."
Gradante cites Whitfield v. Cohen, in which the decision noted that the fiduciary and its general partner "did not know nor could it inquire as to the nature of the manager's investments." Furthermore, the ruling stated, "the fiduciary had a duty ... to withdraw the investment if it became clear or should have become clear that the investment was no longer proper for the Plan." Subsequently, the fiduciary was held liable because it was not able to solicit information about the account and therefore was not able to discern whether such an investment would meet with its objectives.
He also mentions the Liss v. Smith decision, which states: "The duty to monitor carries with it, of course, the duty to take action upon discovery that the appointed are not performing properly." This duty is expected of pensions' fiduciaries, but it is not possible under funds of funds agreements that include clauses such as the abovementioned, Gradante explains.
Darren Spencer, research consultant with Aon Consulting, says the notion of pension plans committing an illegal act by investing in funds of funds "seems outrageous." He notes that many corporate pension funds have invested in funds of funds and that the documents have been reviewed by lawyers. Furthermore, he finds the suggestion that pension plans are giving up their right to sue "bizarre" and is not sure this is entirely accurate.
However, some lawyers insist that there could be a potential problem.
If a fund of funds does have such a clause in the contract, the agreement may, in fact, be prohibited under ERISA, and "the Department of Labor would deem it an unsuitable investment," comments one attorney. "If a subscription document takes these rights away, then the fiduciary may be in violation of ERISA," he says.
Not necessarily true, counters another ERISA expert who spoke on condition of anonymity. "It is not a violation per se to sign on to an investment that contains such language."
He noted that there are two types of limitations that are relevant to this restrictive clause noted by Gradante: the ability to receive information on an underlying investment and the ability to sue the parties managing the fund.
With respect to the first limitation, the expert said that it "doesn't appear that [the clause] would interfere" - unless the investment fund holds plan assets of at least a 25% investment.
"My understanding is that a lot of hedge funds do not hold plan assets," he said, which would then mean that such investors would not exceed this 25% investment. Nevertheless, "there is a small area where this might apply," said the source.
With respect to the 25% investment, David Cohen, a partner with Schulte Roth & Zabel LLP, a New York City-based law firm, did note that the more basic principal regarded the 25% of asset investment. Cohen, who has never seen the aforementioned clause in an agreement and so did not comment on whether it would be an ERISA violation or not, stated that with regard to the over 25% investment, these fund of funds managers are considered ERISA fiduciaries. He also indicated that plans with under a 25% investment would not have to report information, but that he was not sure of those over 25%. He agreed that most funds of funds are under the 25% investment, but that this is starting to change.
With respect to a plan signing an agreement that takes away the right to sue, the ERISA expert acknowledges that while this should be taken into account, he is "not sure if the lack of ability in and of itself would make the plan imprudent." He also questions whether such an agreement would be enforceable, not under ERISA, but under general notions of contract law.
The Department of Labor declined to comment on the issue, other than to note the following:
"Under ERISA, plan fiduciaries responsible for investing plan assets have a general duty to do so prudently and solely in the interest of the plan and its participants and beneficiaries. In fulfilling this obligation, fiduciaries must secure sufficient information to understand an investment prior to making the investment, and must ensure that they have access to sufficient information to enable them to monitor the ongoing prudence of the investment. Whether a fiduciary has acted prudently with respect to a particular investment decision is a factual question. In making its decision, the fiduciary must take into account all relevant facts and circumstances surrounding the investment arrangement, including the terms and conditions of the plan's investment contract."
The DOL also referred to a DOL advisory opinion issued Aug. 20, 2002, available at www.dol.gov/ebsa. The opinion was issued in response to a request for an opinion on behalf of the Central Pension Fund of the International Union of Operating Engineers and Participating Employers concerning the fiduciary provisions of ERISA. One paragraph of the letter that may be relevant to the fund of funds issue reads as follows:
The Department does not believe that, in and of themselves, most limitation of liability and indemnification provisions in a service provider contract are either per se imprudent under ERISA section 404(a)(1)(B) or per se unreasonable under ERISA section 408(b)(2). The Department believes, however, that provisions that purport to apply to fraud or willful misconduct by the service provider are void as against public policy and that it would not be prudent or reasonable to agree to such provisions. Other limitations of liability and indemnification provisions, applying to negligence and unintentional malpractice, may be consistent with sections 404(a)(1) and 408(b)(2) of ERISA when considered in connection with the reasonableness of the arrangement as a whole and the potential risks to participants and beneficiaries. At a minimum, compliance with these standards would require that a fiduciary assess the plan's ability to obtain comparable services at comparable costs either from service providers without having to agree to such provisions, or from service providers who have provisions that provide greater protection to the plan.
Behind the times
Another point of contention seems to be whether such clauses are as common today as they were five or even 10 years ago.
David Nissenbaum, a partner with Schulte Roth & Zabel LLP, says that he doesn't know whether or not the quote shows up all the time, but he says the idea behind it is true and "clearly applicable. ... There is no transparency when you invest in a hedge fund or a fund of funds," he says. Nissenbaum does acknowledge, though, that it is not clear exactly how much information should be provided in terms of investments.
Charles Crow, a lawyer with Crow and Associates, a law firm that practices exclusively in alternative investments, and a member of the Managed Funds Association, the Washington, D.C.-based advocacy group for the industry, states, however, "I'm not sure if this is typical language for a fund of funds. ... This might have been true as recently as seven to 10 years ago. But the tendency [now] is to give as much transparency as possible."
Crow, however, acknowledges, "Sure, you can find a fund of funds that offers no transparency whatsoever ... [and] you find money managers who haven't gotten with the program," but this is against the trend.
"Both the fund of funds and hedge fund industries and the pension plan industry have become a lot more sophisticated about each other; their knowledge and relationships have continued to grow. You've not seeing pensions run whole hog into alternatives," he says.
"I hope there is an increased amount of prudent - and I would underline prudent' - investing of pension plans in asset classes," says Crow.
Ultimately, one point is clear: It is imperative that pension plans read the fine print when signing a fund of funds agreement. While some of the wording may be of more concern to some than others, there do seem to be some gray areas that may be open to interpretation. - A.M.