For many investment managers, the ability to act as “QPAM” is essential to managing retirement account assets. Indeed, status as a QPAM likely provides a sort of credentialing boost in the eyes of prospective plan clients and, more importantly, signals the investment manager’s ability to rely upon the “QPAM Exemption,” a highly versatile exemption used to cure various prohibited transactions under ERISA and Section 4975 of the Internal Revenue Code when it exercises discretion over plan assets. To be a QPAM, however, is not tantamount to satisfying the QPAM Exemption. Moreover, the QPAM Exemption itself is subject to myriad conditions, the failure to meet only one of which can wreak havoc on a compliance strategy. Here, we provide an overview and highlight potential trap doors in a Q&A format.
What is a QPAM?
A QPAM is a “qualified professional asset manager” within the meaning of Part VI(a) of the QPAM Exemption (Prohibited Transaction Class Exemption 84-14). An investment adviser registered under the Advisers Act, for example, is generally eligible to be a QPAM, provided it has total client assets under management of more than $85 million as of the last day of its most recent fiscal year and more than $1 million in shareholders’ or partners’ equity. Thus, newly formed investment managers may need to rely on an alternative exemption for trading, such as Section 408(b)(17) of ERISA, during its first year of operations.
What is the QPAM Exemption, and why is it important?
Fiduciaries of employee benefit plans subject to Title I of ERISA and plans subject to Section 4975 of the Internal Revenue Code (e.g., IRAs) must avoid entering into prohibited transactions for which no exemption is available. A prohibited transaction includes the purchase and sale of securities or other property to a “party in interest.” For example, a swap transaction with a bank would be a prohibited transaction if the bank is a party in interest to the plan client. Virtually all financial service firms will assume they are a party in interest. This is why nearly all ISDA Schedules will include representations from the investment manager that the QPAM Exemption will be met with respect to the transactions. Simply, an investment manager may be hard-pressed to enter into many types of transactions on behalf of plan clients without representing that it can satisfy the QPAM Exemption (while the bank-counterparty in this example may seek a representation from the investment manager that it is a QPAM, the bank would only be interested in knowing that in the context of ensuring the QPAM Exemption can otherwise be met).
To be fair, the QPAM Exemption is not the only game in town. It is, however, a tried and true exemptive approach that facilitates many types of trades an investment manager may want to conduct on behalf of a plan client. Reliance on alternative exemptions may be feasible from a legal standpoint but nevertheless could slow negotiations down. Practically speaking, then, it is important for most investment managers who have discretionary responsibility over plan assets to become familiar with the nuances of the QPAM Exemption and ultimately comply with it.
For purposes of the prohibited transaction rules, is it enough to be a QPAM?
An investment manager’s status as a QPAM is important, but only insofar as the rest of the QPAM Exemption can also be satisfied. In other words, the QPAM Exemption contains several conditions; to meet the definition of a QPAM itself is but one condition.
What are the other conditions of the QPAM Exemption?
Here is an overview of the other key conditions of the QPAM Exemption:
- The investment manager (i.e., the QPAM) acknowledges in writing that it is a fiduciary to the plan client.
- The entity appointing the QPAM (or entering into the investment management agreement with the QPAM) is not the counterparty (or affiliate) with respect to the transaction. There is a useful exception to this condition for commingled investment funds where no plan (or plans established by the same employer) holds a 10 percent or more interest in the fund.
- The counterparty is not the QPAM or otherwise related to the QPAM (i.e., the QPAM Exemption does not cover self-dealing prohibited transaction issues).
- No plan, when combined with the assets of other plans established by the same employer, represents more than 20 percent of the QPAM’s total client assets under management.
- The terms of the transaction are negotiated by the QPAM, and the QPAM makes the decision to enter into the transaction on behalf of the plan.
- The terms of the transaction are at least as favorable to the plan as the terms generally available in an arm’s length transaction between unrelated parties.
- Neither the QPAM, any affiliate, nor certain other persons have been convicted of certain U.S. or non-U.S. crimes (e.g., larceny, forgery, theft, counterfeiting, etc.) within the past 10 years. This condition has proven challenging for some large financial services firms with affiliates around the globe that may have been convicted of non-U.S. crimes.
Each and every one of these conditions have to be met.
How should an investment manager proceed?
As evident from the conditions outlined above, the QPAM Exemption cannot be put on autopilot. Investment managers should be cognizant that satisfaction of the QPAM Exemption needs to be battle-tested prior to making a contractual representation to a client or a counterparty that the exemption can be complied with by the investment manager. Investment managers should also be sensitive to the fact that some clients of theirs may conflate an investment manager’s status as a QPAM with the investment manager’s ability to satisfy the QPAM Exemption. Should this occur, both parties may have a false sense of security that the QPAM Exemption can be met for the investment mandate. The existence of non-exempt prohibited transactions by an investment manager can result in severe monetary penalties and reputational harm. If the QPAM Exemption is unavailable for some reason, one or more alternative exemptions may be available, though they should be evaluated prior to entering into the investment management agreement and any trading.
The U.S. Department of Labor (DOL) has reinstated the five-part test for when one becomes a fiduciary to retirement investors (e.g., ERISA plan sponsors, participants, IRA owners, etc.) by reason of giving non-discretionary investment advice. While at first blush the reinstatement seems to offer great relief to various financial institutions that were possibly ensnared under the DOL’s tricky 2016 conflicts of interest rule, private fund sponsors, broker-dealers and investment advisers should proceed with caution. Interpretations by the DOL over the second half of 2020 suggests it will liberally interpret (and enforce) the five-part test for when one becomes an investment advice fiduciary. Tellingly, that the Trump administration opted to expansively interpret the five-part test to the point that it has more than a passing resemblance of the 2016 conflicts of interest rule under the Obama administration suggests that, regardless of which party controls the Executive Branch, the risks of becoming a fiduciary have increased and the opportunities to avoid such status have inexorably winnowed.
Under the test, a person provides “investment advice” if he or she: (1) renders advice to a plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property; (2) on a regular basis; (3) pursuant to a mutual understanding; (4) that such advice will be a primary basis for investment decisions; and that (5) the advice will be individualized to the plan. In addition to satisfying the five-part test, a person must also receive a fee or other compensation to be an investment advice fiduciary.
All five conditions of the test must be satisfied, plus the receipt of compensation (direct or indirect), for there to be fiduciary investment advice.
The linchpin is that, in order to be an investment advice fiduciary, the financial institution must receive a direct or indirect fee or other compensation incident to the transaction in which investment advice has been provided, in addition to satisfying the 5-part test. The DOL reiterated its longstanding position that this requirement broadly covers all fees or other compensation incident to the transaction in which the investment advice to the plan has been rendered or will be rendered. This could include, for example, an explicit fee or compensation for the advice that is received by the adviser (or by an affiliate) from any source, as well as any other fee or compensation received from any source in connection with or as a result of, the recommended transaction or service (e.g., commissions, loads, finder’s fees, revenue sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to firms in return for shelf space, recruitment compensation, gifts and gratuities, and expense reimbursements, etc.).
Condition #1: “renders advice to a plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property”
The DOL appears to interpret “securities or other property” broadly to include not only recommendations of specific investments but also any recommendation that would change fees and services that affect the return on investments. This means:
- A recommendation of a specific security or fund would meet this requirement.
- A recommendation of a third-party investment advice provider (likely both non-discretionary discretionary, though this is not clear) would meet this requirement.
- A recommendation of one’s own products or services, which is accompanied by an investment recommendation, such as a recommendation to invest in a particular fund or security, would meet this requirement.1
- A recommendation to switch from one account type to another (e.g., brokerage vs. advisory, commission-based to fee-based) would meet this requirement.
- A recommendation of a third party who provides investment advice for which a referral fee is paid would most likely meet this requirement.
- A recommendation to take a distribution/rollover from a plan into an IRA or from one IRA to another IRA would most likely meet this requirement.2
- A recommendation of an investment strategy/policy or portfolio composition may meet this requirement.
But some communications will not, without more, give rise to a “recommendation” under prong #1. These include:
- Marketing one’s products and services.3
- Investment education, such as information on general financial and investment concepts, (e.g., risk and return, diversification, dollar-cost averaging, compounded return, and tax deferred investment).
- Simply describing the attributes and features of an investment product.
Condition #2: “on a regular basis”
Looks can be deceiving, and that is certainly the case with the “regular basis” requirement. While it would appear to be self-evident, the DOL’s expansive view of this condition should cause service providers to tread carefully. This is because:
- A one-time sales transaction that is a recommendation would be on a “regular basis” if it were deemed part of an existing or future investment advice relationship with the retirement investor or there is otherwise an expectation by the investor that the sales communication is part of an investment advice arrangement.
- An investment recommendation would be on a “regular basis” if it were made on a recurring and non-sporadic basis, and recommendations are expected to continue. Advice need not be provided at fixed intervals to be on a “regular basis.”
- A rollover recommendation to a participant who has previously received investment advice from the financial institution would be on a “regular basis.”
- One-time investment advice to a plan sponsor of an ERISA plan, when the financial institution has provided the plan sponsor investment advice with respect to its other ERISA plans, would be on a “regular basis.”
On the other hand:
- Sporadic or one-off communications are unlikely to be considered on a “regular basis.”
Conditions #3 and #4: “pursuant to a mutual understanding” “that such advice will be a primary basis for investment decisions”
Whether there is a mutual understanding between the parties that communications are—or are not—investment advice turns on the contractual terms and the surrounding facts and circumstances. Here are some markers:
- Does the written agreement expressly provide for investment advice, or does it expressly and clearly disclaim that any investment advice is intended to be provided? The answer to this is not determinative, but it will factor into the position the DOL takes on whether this condition was met for purposes of the 5-part investment advice test.
- Would a Retirement Investor reasonably believe the financial institution was offering fiduciary investment advice based on the financial institution’s marketing and other publicly available materials? Does the financial institution hold itself out as a “trusted adviser”?
The DOL also confirmed that the advice need only be a primary basis, not the primary basis.
Condition #5: “the advice will be individualized to the plan”
The DOL did not elucidate on this requirement in the new rule. A good rule of thumb, however, is that the more individually tailored the communication is to a specific recipient, the more likely the communication will be viewed as a recommendation by the DOL.
Financial institutions, especially those that believe they do not provide investment advice to retirement investors, should carefully consider whether the DOL’s expansive view of these requirements alters their status as a fiduciary so that they do not inadvertently cause a non-exempt prohibited transaction. An accompanying class exemption goes into effect on February 16, 2021 and would be available for those who become investment advice fiduciaries
1 It is crucial to note that the DOL’s 2016 conflicts of interest rule included an exception for incidental advice provided in connection with counterparty transactions with a plan fiduciary with financial expertise. As the DOL noted then, “[t]he premise… was that both sides of such transactions understand that they are acting at arm’s length, and neither party expects that recommendations will necessarily be based on the buyer’s best interests, or that the buyer will rely on them as such.” The new rule, however, contains no such exception.
2 In the DOL’s eyes, a financial institution that recommends a rollover to a retirement investor can generally expect to earn an ongoing advisory fee or transaction-based compensation from the IRA, whereas it may or may not earn compensation if the assets remain in the ERISA plan.
3 As noted above, the DOL will only treat the marketing of oneself as a “recommendation” if such communication is accompanied by a specific recommendation of a product or service. It is unclear whether the DOL will look for a recommendation of a product or service in fact or in effect, a thorny issue similarly raised under the predecessor 2016 rulemaking.