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ERISA Benefit Plan Investment Management Agreements: Selecting 3(38) Investment Managers, Structuring the IMA

Documenting the Relationship to Minimize Risks for Plan Sponsors and Investment Advisers Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, APRIL 18, 2017

Sharon M. Goodman, Principal, Slevin & Hart, Washington, D.C. David A. Russell, CFA, Senior Investment Strategist, Senior Consultant, Investment Performance Services, Newtown, Pa.

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ERISA Benefit Plan Investment Management Arrangements

Presented by:

Sharon Goodman, Esq. David A. Russell, CFA

Principal Senior Investment Strategist Slevin & Hart, P.C. Investment Performance Services, LLC Washington, D.C. Newtown, PA (202) 797-8700 (215) 867-2330 sgoodman@slevinhart.com drussell@ips-net.com www.slevinhart.com www.ips-net.com April 18, 2017

Presentation Overview

I. Due Diligence and Selection of ERISA 3(38) Investment Manager Fiduciaries – David Russell II. Negotiating and Contracting With ERISA Section 3(38) Discretionary Investment Managers – Sharon Goodman III. Monitoring ERISA Section 3(38) Discretionary Managers – David Russell IV. Questions

Part I Due Diligence and Selection of ERISA 3(38) Investment Manager Fiduciaries David Russell

7

What is a Section 3(21) vs. Section 3(38) Fiduciary?

ERISA Section 3(21) provides that any party giving investment advice for a fee is a plan fiduciary. Investment Consultants traditionally fall into this category and their contractual duties are to advise, report, monitor and recommend, but they have no discretion or authority to make decisions or implement changes to the plan. ERISA Section 3(28) defines “investment managers” who are also plan fiduciaries, but they are specifically delegated the discretion, authority and responsibility for making and implementing investment decisions. Traditionally, investment manager discretion has been contractually limited to selecting, buying, holding and selling specific types of securities and are subject to specific limitations and guidelines as specified in a written Investment Policy Statement. The main difference between ERISA Section 3(21) and ERISA Section 3(38) is discretion

8

What is a Section 3(21) vs. Section 3(38) Fiduciary?

Delegation of fiduciary control from Trustees to investment manager

• nly occurs if manager is ERISA Section 3(38) fiduciary.

Plan sponsors are increasingly considering delegating much or all of the investment decision making to consultants and/or investment managers. This concept has been referred to by several terms, including:

• Discretionary Consulting
• Discretionary Management
• Outsourced Chief Investment Officer (OCIO)

Regardless of the term used, or the type of organization providing the service, they are plan fiduciaries that have discretion over plan assets and have the authority to make decisions. They therefore fall under ERISA Section 3(38) definition of an “investment manager.” That also means they have legal responsibility and liability for their decisions.

9

10

Selecting ERISA 3(38) Fiduciaries

Potential Vendors: ERISA Section 3(38) Investment Manager Fiduciaries providing OCIO or Discretionary services can be:

• Investment Managers
• Investment Consultants
• Financial Planners
• Banks
• Insurance Companies
• Mutual Fund Companies
• Other Financial Institutions

Due Diligence Process:

• Trustees should document their due diligence process in selecting a 3(38)

fiduciary.

• The process should be comprehensive and thorough - Trust but verify!
• Trustees still have a duty to monitor the fiduciary!

11

The Due Diligence Process

Using a written Request For Proposal (RFP) process is typical:

• Provides written documentation of the process;
• Comprehensive information is obtained;
• Questions cover all relevant services and standards of performance;
• Structures information in a common format, which makes it easier to rate

and rank vendors;

• Provides competitive market data for services and fees.

12

The Due Diligence Process

1. Firm Data 2. Legal and Regulatory 3. Business Continuity, Disaster Recovery, Data Integrity 4. Operations and Trading 5. Investment Philosophy and Strategy 6. Track Record 7. Fees

13

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 1) Firm Data:

• Location, legal structure, ownership, history, revenue, assets managed,

management, organizational structure, number of employees, staff turnover.

• Range and number of firm-wide products and services offered,
• Types and longevity of clients.
• Experience and staffing of 3(38) Discretionary/OCIO services:
• Number, nature, longevity and size of current 3(38) clients;
• Number, background, experience and history of staff;
• References
• Personnel Policies and Practices: Diversity, non-discrimination,

compensation structure and incentives.

14

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 2) Legal and Regulatory:

• SEC, FINRA or other registrations (Form ADV Parts I and II)
• Regulatory investigations, complaints or disciplinary actions (Edgar.com)
• Qualified Professional Asset Manager (QPAM) status
• Date and outcome of any regulatory reviews
• Litigation history
• Insurance Coverage: Professional Liability, E&O, D&O, ERISA Fiduciary

Liability and Bonding

• Code of Ethics
• Personnel Compliance – Policies, staffing, monitoring process, reporting

exceptions

15

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 3) Business Continuity, Disaster Recovery, Data Integrity

• Information technology and software systems used
• Data back up plan and testing
• Remote site for operations, trading and data access
• Firewalls, breach protection, denial of service protection
• Natural disaster and pandemic plans and testing.

16

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 4) Operations and Trading:

• Account setup (onboarding) process
• Compliance with Investment Policy and Guidelines
• Account monitoring and exception reporting process
• Compliance software and staff training
• Trading policies and practices
• Trading systems and custodian/counter-party reconciliation process.
• Derivatives practices, counter-party exposures, collateral/cash

management (ISDA terms)

• Process for measuring and monitoring trading costs and “best execution”
• Soft dollar practices, services and budget
• Flow of transactions from investment team – traders – middle office- back
• ffice – compliance – accounting
• Independent audits of fund and firms
• Proxy voting policy and reporting

17

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 5) Investment Philosophy and Strategy

• Overall investment philosophy
• Beliefs regarding: fundamental vs. quantitative, active vs. passive,
• liquid vs. illiquid, allocations to alternatives, complex strategies,

derivatives, leverage, asset classes and strategies used vs. avoided

• Investment vehicles used: legal structure, open architecture vs. proprietary

products.

• Custody of assets – Independent custodian or internal/proprietary custody.
• Development of investment policy and guidelines
• Experience and software for asset and liability modeling
• Single allocation model vs. client customization
• Risk management, measurement and monitoring methodologies (Std Dev,

VaR, down-side, factor-based, risk budgeting, etc.)

• Performance reporting systems
• Research and investment information resources

18

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 6) Track record

• Return history (monthly data with Quarterly, Annual and Cumulative

results)

• Benchmarks used and how selected?
• Universe rankings
• Monthly/quarterly data volatility
• How are composites constructed?
• How difference risk levels handled?
• What other composites are there?
• Are any client portfolios not included in composites and why?
• Are composites compliant with Investment Performance Reporting

Standards (GIPS)? Provide GIPS independent audits.

19

The Due Diligence Process

Request For Proposal (RFP) questions typically cover: 7) Fees

• Fee Structure: Flat fees, % of assets or a combination
• Incentive fees – high water marks, claw-backs, catch-ups
• Fee sharing from underlying investments -12(b)(1) fees or rebates/offsets
• Fund operating expenses and/or management fees for proprietary funds
• Frequency of billing and transparency of fees

20

The Due Diligence Process

Some plans use a Rating Matrix to compare and rank vendor responses to the RFP

21

Part II Negotiating and Contracting With ERISA Section 3(38) Discretionary Investment Managers Sharon Goodman

22

Plan Document Considerations

• ERISA Section 404(a) requires Trustees to discharge their duties in

accordance with document governing the Plan.

• Do your Plan governing documents allow for this investment?

– Trust Agreement – Investment Policy

• So Trustees decision to invest in private equity is breach of fiduciary duty

under ERISA Section 404(a) if Plan’s investment policy prohibits private securities.

• Avoid unnecessary ERISA fiduciary breach issue

23

Who is the Fiduciary For the Investment?

HAVE TRUSTEES DELEGATED THEIR FIDUCIARY CONTROL TO MANAGER?

• Who is ERISA fiduciary for ongoing investment decisions – Trustees or investment

manager?

• Does Investment Hold Any ERISA Plan Assets?
• If NO, Trustees remain fiduciary for ongoing investment decisions by manager.
• If YES, is Participation By ERISA Benefit Plan Investors 25% or more of Investors?
• If ERISA Plan Assets less than 25%, Manager does not control plan assets so cannot be

ERISA fiduciary or Section 3(38) manager.

• If YES, manager is ERISA fiduciary so can be ERISA Section 3(38) manager for ongoing

investment decisions if acknowledges that status in writing.

• Trustees’ decision – will you pick a manager/investment that is not an ERISA fiduciary?

24

The Plan Asset Rule Under ERISA

• BASICS: When ERISA plan invests in equity of any entity, both equity

interest and proportionate interest in that entity’s assets treated as assets

• f ERISA plan, unless exception applies.
• MOST COMMON EXCEPTIONS:

– Investment in publicly offered security – Investment issued by investment company registered under 1940 Act – Investment by benefit plan investors not significant – Investment in venture capital operating company – Investment in real estate operating company

• If exception applies, Trustees have not delegated fiduciary control to

Manager.

• Trustees remain fiduciary in control of those plan assets.

25

Public Securities

• ERISA plan buys publicly offered securities.
• Publicly offered security is security that is:

– Freely transferable; – Widely held (at least 100 independent investors on issue date); – SEC registered.

• Example: ERISA Trustees use plan assets to buy Facebook stock.
• Mark Zuckerberg is not fiduciary to ERISA plan – does not control plan

assets.

• ERISA plan does not negotiate with Facebook on terms of purchase
• No investment management agreement with Facebook
• Trustees have not delegated fiduciary control to manager of operating

company.

• Trustees remain fiduciary in control of those plan assets.

26

Investment In Registered Investment Company

• ERISA plan buys securities issued by investment company registered under

Investment Company Act of 1940.

• Example: ERISA plan buys shares of Vanguard mutual funds.
• Vanguard mutual fund manager not fiduciary to ERISA plan – does not control

plan assets.

• ERISA plan (usually) does not negotiate with Vanguard on terms of purchase.
• No investment management agreement with Vanguard-usually just application

to buy shares.

• Trustees have not delegated fiduciary control to manager of operating company.
• Trustees remain fiduciary in control of those plan assets.

27

Investment by Benefit Plans Not Significant

• Benefit plan investment “significant” if benefit plan investors hold 25% or

more of any class of equity interests by value.

• Pension Protection Act: Foreign plans and other non-ERISA plans no

longer count toward 25% limit.

• 25% excludes entity controlling investment and its affiliates (example:

general partner of partnership) or rendering investment advice for fee excluded in applying 25% limit.

• Trustees have not delegated fiduciary control to manager of operating

company.

• Trustees remain fiduciary in control of those plan assets.

28

Investment by Benefit Plans Not Significant

• Example: ERISA plan buys shares of Great Dane Opportunities Fund, Ltd.,

limited liability corporation formed to invest in privately held companies.

• Great Dane Opportunities Fund, Ltd. managed by Slobber Management,

L.P.

• Dubai Sovereign Pension Plan owns 10% of equity interest in Great Dane

Opportunities Fund.

• ERISA benefit plan investments own 15% of equity interest in Great Dane

Opportunities Fund.

• Slobber owns 8% of equity invest in Great Dane Opportunities Fund.
• Slobber not fiduciary to ERISA plan – does not control plan assets because

ERISA plan investors hold less than 25%.

• BUT ERISA plan (usually) does negotiate with Slobber over side letter to

modify terms to buy equity interest in Great Dane Opportunities Fund.

29

Investment In Operating Company

• Operating company = entity primarily engaged, either directly or through

majority owned subsidiaries, in production or sale of product or service.

• Most common encountered by ERISA plans

– venture capital operating company – real estate operating company

• Manager of operating company does not control ERISA plan assets of plan

investors in company.

• Trustees have not delegated fiduciary control to manager of operating

company.

• Trustees remain fiduciary in control of those plan assets.

30

Venture Capital Operating Company

• ERISA plan investment in Venture Capital Operating Company (VCOC) Not

Plan Assets Subject to ERISA

• Common in private equity strategies.
• VCOC is entity with at least 50% of its assets invested in “venture capital

investments” in which it has “management rights.”

• Management rights = rights to substantially influence management of the
• perating company.
• Must be “direct” rights that VCOC can exercise.
• Asset/management tests done annually.
• Under exception, manager of VCOC does not control ERISA plan assets of

plan investors in VCOC

• BUT ERISA plan (usually) does negotiate with VCOC on terms of side

letter to buy equity interest in VCOC

31

Real Estate Operating Company

• REOC is entity with 50% or more of its assets invested in qualifying real

estate and directly engaged in real estate management or development activities.

• Tested with first investment and annually thereafter.
• Under exception, manager of REOC does not control ERISA plan assets of

plan investors in REOC

• BUT ERISA plan (usually) does negotiate with REOC on terms of side

letter to buy equity interest in VCOC

32

Issues Under Investment Contract

Type of Investment Drives Contract Terms

• Is this a separate account or a commingled/collective trust or

something else?

• Separate Account
• Commingled/Collective Trust
• Or does an exception to Plan asset rules apply?

33

Separate Account Investment

• Direct investment management agreement between ERISA plan and

investment manager

• Investment manager is ERISA Section 3(38) fiduciary for investment

because it controls plan assets if it acknowledges that status in writing

• Trustees delegate fiduciary duty for those plan assets to manager.
• Plan’s investment policy governs manager’s strategy.

34

Separate Account Investment

Example: ERISA plan hires PIMCO to manage fixed income strategy in separate account

• Assets held at plan’s custodial bank
• PIMCO controls purchase and sale of bonds held in account
• PIMCO is fiduciary and ERISA Section 3(38) to ERISA plan because it

controls plan assets and acknowledges it in contract.

• ERISA plan negotiates with PIMCO over investment management

agreement

35

If Commingled/Collective Trust Investment

• Direct agreement between ERISA plan and collective trust that investment

manager controls.

• Investment manager is ERISA fiduciary and Section 3(38) manager for

investment because it controls plan assets and acknowledges it in contract.

• Trustees delegate fiduciary duty for those plan assets to manager.
• Manager’s investment policy governs trust’s strategy.

36

If Commingled/Collective Trust Investment

• Example: ERISA plan participates in Amalgamated Bank S&P 500 Index

Fund.

• Assets held at Amalgamated Bank custody account.
• Amalgamated Bank controls purchase and sale of stocks held in account.
• Amalgamated Bank is fiduciary to ERISA plan – directly controls plan

assets.

• ERISA plan (maybe) negotiates with Amalgamated Bank PIMCO over

participation agreement.

37

Special Delegation Issues

• Named Fiduciary = only fiduciary with ability to delegate its ERISA fiduciary

duty to another fiduciary

• Must be identified in Plan Document (Trust Agreement)
• Board of Trustees/Retirement Committee usually Named Fiduciary
• “Master manager” of hedge fund of funds

– Does master manager also want to be a named fiduciary to delegate ERISA fiduciary duty to sub-managers/underlying investment funds? – Does Trust Agreement allow designation of master manager as named fiduciary? – If not, does master manager acknowledge that it is liable for sub- manager’s actions?

38

Issues For Negotiation Under Investment Contract

Negotiations Over Investment Management Agreement or Side Letter To Commingled/Collective Investment Documents

• Separate account – negotiating terms of direct investment management

agreement

• Commingled fund – negotiating terms of plan’s side letter to “clarify” fund

documents that apply to all investors

• Non-Plan asset investment – negotiating side letter (usually) to “clarify”

fund documents that apply to all investors

39

Issues For Negotiation Under Investment Contract

Standard of Care – For ERISA fiduciary manager = ERISA fiduciary standard – If not ERISA fiduciary manager (because one of the exceptions applies) = negotiate whether ERISA-like contractual standard or ERISA-light contractual standard (prudence standard only)

40

Issues For Negotiation Under Investment Contract

Indemnification

• Relevant whether ERISA fiduciary manager or not
• Investment documents should (try) to:

– Require manager to indemnify Plan and Trustees – Often mutual/parallel indemnification by plan of manager and manager

• f plan

– If so, make clear that ERISA plan – AND NOT TRUSTEES—liable for any indemnification – Beware of “signatory below shall indemnify......”

41

Issues For Negotiation Under Investment Contract

Fees

• Most Favored Nations (“MFN”) Treatment on Fees, Rights and

Features – All investors? – Similar sized investors? – Count affiliated investor plans?

• Incentive Fees

– Warrant under DOL guidance? – Valuation of Portfolio and Potential Conflicts

• Claw back If Incentive Fees

– Avoid heads manager wins, tails fund loses – How is high-water mark for payment of incentive fees set and reset?

42

Issues For Negotiation Under Investment Contract

• More Fees -- Unrelated Business Taxable Income

– Effort to avoid? – Protections if taxable income is earned? – Impact of tax on net return/incentive fee?

• Key Man Provisions – If strategy depends on superstar/few key

people, what happens if they are unwilling or unable to continue to manage investment?

43

Issues For Negotiation Under Investment Contract

Confidentiality

• When can manager release ERISA plan’s information?

– What notice is required to plan? – Disclose to manager’s potential clients? – When can plan prevent disclosure?

• When can ERISA plan release information about investment?

– Any limits on what ERISA plan can disclose? – What notice is required to manager? – Disclose to plan’s professionals to operate ERISA plan? – When can manager prevent disclosure? – Section 101(k) for multiemployer plans

• Special issue – DOL, IRS audits

44

Issues For Negotiation Under Investment Contract

Reporting

• Sufficient for ongoing monitoring by plan’s investment consultant?
• Sufficient for ERISA plan’s auditor to prepare financial statements?
• ERISA plan auditor needs financial statement of underlying investments

“tiered” investment structure – example, in hedge fund.

45

Issues For Negotiation Under Investment Contract

• Conflicts of Interest

– Avoided, either because manager is ERISA fiduciary or by contract?

• Bonding

– ERISA Section 412 requires any person handling plan assets to be bonded – ERISA fiduciary manager should have own bond

• Proxies

– Agreement should make clear who votes proxies (if any)

46

Issues For Negotiation Under Investment Contract

• Termination of Agreement

– For separate account investment, usually at any time – If commingled/collective vehicle – what is frequency/ liquidity? – Timing of notice

• Redemptions/Liquidation of Investment

– When and with what notice period? – Does strategy make liquidation impractical or inadvisable even if unrestricted? – What is fund getting back—in kind securities or cash? – If in kind securities, who manages until liquidated and for what fee?

47

What Is A QPAM?

• “Qualified Professional Asset Manager” (“QPAM”) is investment

professional that meets regulatory and asset minimums under Prohibited Transaction Exemption (PTE) 84-14.

• PTE 84-14 is a class exemption – applies to transactions that meet the rules

in PTE – no separate filing with DOL to meet exemption.

• Under PTE 84-14, as amended, QPAM is entity meeting definition of

investment manager that also has substantial assets – Bank with equity capital in excess of $1,000,000 – Insurance company with net worth in excess of $1,000,000, or – Registered investment adviser with total client assets under management in excess of $85,000,000 and with partners/shareholders equity in excess of $1,000,000.

48

Rules to Meet QPAM Exemption

QPAM transaction must meet following rules:

• Assets of plan (and related plans) in transaction cannot exceed 20% of all

assets managed by QPAM.

• Terms of transaction must be at least as favorable to plan as terms

available in arm’s length transaction.

• Counterparty (and its affiliates) cannot have power to appoint or terminate

QPAM as manager of plan assets or to negotiate for plan over terms of QPAM’s engagement.

49

When To Consider Using QPAM?

• PTE 84-14 provides limited exemption to prohibited transaction rules for

specified transactions involving plan assets managed by QPAM and limited group of parties in interest unrelated to and with no direct or indirect control

• ver QPAM.
• Result: QPAM Exemption allows Section 3(38) manager to engage in

certain party-in-interest prohibited transactions in investment that otherwise would violate ERISA fiduciary conflict in interest rules.

• QPAM exemption allows manager to use services of affiliates with violating

the prohibited transaction provisions of ERISA.

• Practical: Manager already a QPAM for investment and structured to use

affiliates as back-office administration for collective trust-so built into investment

• Possible: Fund would consider using QPAM on evaluating investment in

related industry. Example: manager invests in building supermarkets for supermarket industry pension fund.

50

Part III Monitoring ERISA Section 3(38) Discretionary Managers David Russell

51

Investment Monitoring

• ERISA Plan Trustees have a duty to monitor the plan investments.
• That monitoring includes ongoing due diligence and compliance

monitoring of the 3(38) Fiduciary as well as the underlying investments.

• Information flows and investment transparency should be sufficient to

monitor performance, fees, transactions and portfolio holdings.

• Multiple parties, in addition to the Trustees, require detailed information:
• Administrators – Contributions, plan benefit payments, 5500 filings
• Auditor - Audits
• Dept. of Labor – Audits
• Actuary – Actuarial valuations
• Consultants – Performance reporting, risk measurement

52

Investment Monitoring

• Should the Trustees hire an Independent Consultant who is an ERISA

Section 3(21) fiduciary for performance reporting and monitoring of managers?

• Most plan do. Consultants can provide Trustees with:
• Performance reporting
• Risk measurement
• Ongoing manager due diligence
• Compliance monitoring.
• Ongoing manager due diligence and compliance monitoring includes
• ngoing monitoring all of the items originally reviewed in the RFP and

evaluating any changes.

53

Part IV Questions?

54