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July 05, 2017  

Lawyers Pressing Managers on Fiduciary Rule

While hedge fund lawyers continue to decipher new U.S. Labor Department rules governing retirement funds, most are advising their clients to stop accepting capital from most individual retirement accounts.

Under the so-called fiduciary rule, hedge fund marketers are prohibited from earning commissions on sales to IRAs, unless the account holder is represented by an independent fiduciary capable of determining whether the product is in the best interest of the investor. That means self-directed IRAs are off limits for hedge funds and other alternative investments.

“A recommendation by a hedge fund manager to invest in the manager’s own fund would be a prohibited transaction absent an exemption,” said Joseph Cunningham, a partner at law firm Willkie Farr. “For that reason, many of our hedge fund clients will no longer offer funds to IRAs that are not represented by an independent fiduciary.”

The decision is trickier with existing investors who deploy capital via IRAs. “My sense is that while managers may allow existing IRA investors to remain invested, most will not allow new or additional investments from self-managed IRAs,” Cunningham added.

Cushioning the impact of the rule change on the hedge fund industry is the fact that for most fund operators, IRAs represent a small portion of investor capital.

The fiduciary rule, a creation of the Obama Administration, has been criticized by some of President Trump’s economic advisors. It was originally scheduled to take effect in April, but implementation was delayed after the Trump Administration ordered the Labor Department to review the rule. In late May, Labor Secretary Alexander Acosta said there was “no principled legal basis” to delay implementation any further. At the same time, Acosta said his agency would seek additional public comment.

The rule went into partial effect on June 9, with full implementation scheduled for Jan. 1, 2018.

Exactly how the rule applies to alternative-investment managers has been the subject of recent client advisories from law firms including Arnold Porter, Proskauer and Sidley Austin. The fiduciary rule does provide an exemption for “sophisticated” investors. But it only applies to banks, broker-dealers, investment advisors and other professional investors with at least $50 million of assets. And in any case, the exemption is unavailable to self-directed IRAs, regardless of their size.

“Because few options are available for selling and marketing services and products to IRAs, some investment vehicles may decide that the best course of action is to cease offering covered services and products to those customers,” Arnold Porter said in its advisory.

The fiduciary rule also has implications for brokerages whose clients include hedge fund investors. That’s because it requires broker-dealers to pay financial advisors the same compensation for similar types of investments, to discourage them from recommending one product over another solely based on potential commissions.

“This is very difficult to manage with hedge funds, because each hedge fund separately negotiates the fee it pays the brokerage firm,” Cunningham said. That potentially creates “a mismatch between what the brokerage firm earns on a given hedge fund placement and the fee that it must pay its financial advisors for placements across similar funds on its platform.”