In the guise of clarifications relating to criminal convictions and misconduct, the Department of Labor (DOL) has proposed major amendments to Prohibited Transaction Exemption (PTE) 84-14, also known as the QPAM exemption (the Proposal). If adopted in its current form, the Proposal would come dangerously close to a revocation of the exemption by excluding any transactions “planned, negotiated or initiated …in whole or part” by any party-in-interest. In addition, the Proposal would obligate QPAMs to enter into written contractual provisions that would expose a QPAM to such extensive liability that many may no longer be able to afford to service plans. And this provision would require every investment contract referencing the QPAM exemption to be rewritten within 60 days of the publication of the final exemption.
The most alarming aspects of the Proposal have largely flown under the radar. In its press release announcing the Proposal, the DOL outlined six objectives behind the proposed amendments. While the objectives on their face appear reasonable, the actual conditions proposed to attain those objectives should raise concerns for both plans and investment providers. The following is a list of the stated objectives of the Proposal, a summary of the conditions proposed to meet these objectives, and the consequences of the proposed conditions.
Objective: “Clarifying the requisite independence and control that a QPAM must have with respect to investment decisions and transactions.”
Proposal: The prohibited transaction relief provided under the exemption would apply only in connection with an “Investment Fund” that is established primarily for investment purposes. No relief would be provided for any transaction that has been planned, negotiated, or initiated by a party-in-interest, in whole or in part, and presented to a QPAM for approval.
The QPAM exemption has always required that the transaction be negotiated by or under the direction of the QPAM and that the QPAM be the decision maker. The Proposal goes far beyond that and would exclude any transaction “planned, negotiated, or initiated by a party-in-interest.” If read literally, many common and beneficial investment arrangements would no longer be permissible. Investment structures will need to be unwound and restructured at high costs, with no discernable beneficial effect on investing plans. For example:
• It is not uncommon for a QPAM to hire other QPAMs as sub-advisors for a particular strategy of an investment fund. Under the Proposal, it is conceivable that in some cases neither the manager nor the sub-advisors would be able to use the exemption.
• The limitation on any involvement in the “planning” of the transaction may prove to be a trap for plan sponsors, trustees and investment committees that inevitably engage in high-level discussions with QPAMs regarding particular investments. It is unclear the extent to which plan-level fiduciaries would be able to meet with investment managers to discuss performance and strategy.
• Trustees of multi-employer pension plans would likely no longer be able to work closely with managers in developing investment funds to meet the unique needs of such plans.
It is unclear why it should matter if a party-in-interest proposes or initiates a transaction, as long as the approval and terms of the transaction are the ultimate responsibility of a QPAM. It is common for plans and their fiduciaries to be presented with or to identify investment opportunities, but to rely on the QPAM to use its independent judgement in approving the specific transaction. Moreover, there is no explanation as to the extent to which Investment Funds, a defined term, will be considered to have been established “primarily for investment purposes.” The definition of Investment Fund includes, among other things, “any . . . account or fund to the extent that the disposition of its assets (whether or not in the custody of the QPAM) is subject to the discretionary authority of the QPAM.” If the distinction is meant to be one of intent, this would create uncertainty as to what transactions are “covered transactions” for the exemption, which should be one of the most, if not the most, clear-cut part of any exemption.
Objective: “Addressing perceived ambiguity as to whether foreign convictions are included in the scope of the exemption’s ineligibility provision.”
Proposal: The exemption would specifically include foreign convictions, retroactively including any that occurred in the past ten years.
DOL explains that the purpose of the foreign affiliate conviction requirement is because “[a]n ineligibility provision that is limited to US federal and state convictions would ignore these realities and provide insufficient protection for Plans investing through a QPAM’s international affiliates.” That reasoning may be sound but it does not explain why the conviction of a foreign affiliate that is completely disconnected from the plan and the QPAM should have the same result. While this is not a new development, the addition of a retrospective rule in this regard highlights the difficulties inherent with this position.
The retroactivity aspect could prove particularly difficult and disruptive in practice with corporate restructurings at a global level. Corporate restructuring and acquisitions often result in new affiliates joining the group that is aggregated for the 5% control affiliate definition of the exemption, and as a result, managers may unexpectedly lose their QPAM status. In such situations, the QPAM may not even be aware of old convictions involving new affiliates of the enterprise. The same is true with regard to an acquired QPAM’s old enterprise. Will a conviction occurring within the enterprise after the QPAM has left the group, but based on activity while the QPAM was part of the group, taint reliance?
Objective: “Expanding the ineligibility provision to include additional types of serious misconduct.”
Proposal: The Proposal contains a new condition entitled “Integrity.” The DOL could disqualify a QPAM upon a finding that the QPAM or an affiliate has violated any of the Integrity conditions, which cover a broad range of activities including:
Reporting Requirements. Each entity that relies upon the exemption must report the legal name of each business entity relying upon the exemption (and any name the QPAM may be operating under) in an email to the DOL and listing affiliated parties to the QPAM. Prohibited Misconduct. The additional grounds for potential disqualification, in addition to criminal convictions, would include: • any conduct that forms the basis for a non-prosecution or deferred prosecution agreement that, if successfully prosecuted, would have constituted a disqualifying crime described in the exemption;
• any conduct that forms the basis for an agreement, however denominated by the laws of the relevant foreign government, that is substantially equivalent to a nonprosecution agreement or deferred prosecution agreement;
• engaging in a systematic pattern or practice of violating the conditions of the exemption in connection with otherwise non-exempt prohibited transactions;
• intentionally violating the conditions of the exemption in connection with otherwise non-exempt prohibited transactions; or
• providing materially misleading information to the DOL in connection with the conditions of the exemption.
The one time e-mail notice to the DOL is a foot fault waiting to happen – old arrangements will be overlooked, new entities will be created, old entities will be renamed or establish new operating names. The cost assumption that this is a one-time 15-minute activity seems to drastically understate the true cost. The DOL has not articulated any evidence that the prior absence of such a requirement has been problematic. The DOL provides no evidence of the need for or the utility of a published list. Reliance on QPAM is routinely documented in agreements among parties that need to rely on the PTE.
Disqualification upon the occurrence of perceived bad behavior is similar to a provision in PTE 2020-02 covering fiduciary investment advice. While there is some due process contemplated, the preamble notes that the DOL “intends to rely on its enforcement authority and program to detect a QPAM’s participation in disqualifying types of misconduct.” Nonetheless, the possibility of field office examination activity that seeks to disqualify a QPAM, with the potential catastrophic results on the QPAM’s business and potentially the plans they service, is extraordinary. This is particularly true because it includes misconduct of 5% control affiliates.
If the DOL is going to reopen the QPAM Exemption in this manner, it is time to reconsider whether misconduct by affiliates justifies ineligibility, given the track record. Misconduct by the QPAM itself is clearly material; misconduct by foreign or even domestic affiliates has not infected the integrity of QPAMs, based on the public record. The DOL has presented no evidence that the governance/compliance/cultural failure at a remote affiliate leading to a criminal conviction means that the entire enterprise suffers from the same failure. If DOL insists on retaining the affiliate rule, modifications could be made that are protective of plans while avoiding unnecessary consequences and disruptions.
• A certification that the criminal issue of an affiliate has had no bearing on the QPAM’s services for plans (which could be supported in appropriate circumstances by an internal compliance audit, though this is not always necessary) should suffice, and DOL can inquire further through its enforcement program should it have any concerns. That is a less burdensome approach that DOL should be obliged to adopt under the standing Executive Orders regarding regulatory simplification, and even DOL surely wants to get away from the time-consuming supplemental individual PTE process now being used to obtain an exemption upon QPAM disqualification.
• The 5% common control affiliation, which is not supported in any empirical way, should be modified for this purpose. The DOL explains that this level of affiliation is appropriate because of the possibility that a 5% affiliate might have “meaningful control” over the QPAM, who may be an “unknowing participant or benefactor in the conduct.” Why, however, should all QPAMs be subject to the draconian disqualification provisions based on speculation that there may be situations where a person with a small ownership interest may have questionable influence or that the QPAM might have been an innocent and unknowing benefactor of bad behavior? This is especially true when the full definition of affiliate for purposes of the Integrity disqualification provision is considered -- which includes, among others, relatives of those who are in control relationships with the QPAM.
Objective: “Focusing on mitigating potential costs and disruption to plans and IRAs when a QPAM becomes ineligible due to a conviction or participates in other serious misconduct.”
Proposal: A new condition would requires the QPAM to enter into a “Written Management Agreement” with its clients that would include a statement that, in the event of a Criminal Conviction or a Written Ineligibility Notice and for at least a period of 10 years, the QPAM:
• agrees not to restrict the ability of a client plan to terminate or withdraw from its arrangement with the QPAM;
• will not impose any fees, penalties, or charges on client plans in connection with the process of terminating or withdrawing from an Investment Fund managed by the QPAM except for reasonable fees, appropriately disclosed in advance, that are specifically designed to prevent generally recognized abusive investment practices or ensure equitable treatment of all investors in a pooled fund in the event such withdrawal or termination may have adverse consequences for all other investors;
• agrees to indemnify, hold harmless, and promptly restore actual losses to the client plans for any damages that directly result to them from a violation of applicable laws, a breach of contract, or any claim arising out of the conduct that is the subject of a Criminal Conviction or Written Ineligibility Notice of the QPAM or an affiliate or an owner, direct or indirect, of a five (5) percent or more interest in the QPAM;
o Actual losses include losses and costs arising from unwinding transactions with third parties, transitioning plan assets to an alternative asset manager and costs associated with the payment of any excise taxes.
• will not employ or knowingly engage any individual that participated in the conduct that is the subject of a Criminal Conviction or Written Ineligibility Notice regardless of whether the individual is separately convicted in connection with the criminal conduct;
The Proposal would also impose, upon disqualification, a one-year winding-down period. This provision is intended to address the very real issue of harm to plans upon an immediate disqualification. During the winding-down period, the QPAM must provide notice to the DOL and each of its client plans stating its failure to satisfy the Integrity provisions and repeating the written contractual requirements for disqualification.
Plan administrators, trustees and investment committees should take heed that every investment management agreement would have to be re-negotiated and amended within 60 days of the date the final exemption is published in the Federal Register. DOL grossly underestimates the costs of rewriting 40 years of investment contracts. QPAM is a standard provision in virtually every investment management agreement and is included in, for example, ISDM master agreements for derivatives transactions, cleared swap documents, credit facilities and numerous other agreements with hundreds of thousands of plans.
For managers, mandatory contractual provisions that would require QPAMs to pick up all costs of unwinding investment transactions is unprecedented in its punitive nature and has the potential to literally put managers out of business. The DOL estimates that it is conceivable that up to “100 million” dollars in assets might be transferred as a result of these provisions. If this is a realistic estimate for a single QPAM, at the very least it could cause disruptions to a business, considering the QPAM would also be responsible for the transaction costs of such transfers. There can be no justification for such a result, when considering that disqualification can occur because of behavior of a single individual with no real connection to the QPAM. With this much exposure on the line, many providers simply will not be able to afford to take on this level of risk and the QPAM exemption may no longer be a viable solution.
DOL may perceive an exodus of QPAMs from the retirement plan investment marketplace as a neutral factor, but in reality should this occur, it is the plans and participants that will surely be harmed. Plan fiduciaries will have to take the time to, among other things, find new managers and replace investment funds. This activity will take time away from focusing on investment decisions, potentially during a volatile market.
The Proposal is also seriously problematic in its requirement that a QPAM not employ anyone “participating in” prohibited misconduct. While active participation in prohibited misconduct might be grounds for termination of employment, the exemption provides that “participating in” refers not only to active participation in the prohibited misconduct, but also to knowing approval of the conduct, or knowledge of such conduct without taking active steps to prohibit such conduct, including reporting the conduct to the appropriate compliance personnel. Presumably the QPAM is expected to fire any individuals who have any knowledge of misconduct. Remember, however, that this restriction applies throughout an entire enterprise. The QPAM is unlikely to have the authority to take such employment action with respect to affiliates. Moreover, the QPAM may be legally restricted from taking such action under, e.g., collective bargaining agreements and foreign employment laws.
Objective: “Adding a standard recordkeeping requirement that the exemption currently lacks”
Proposal: In addition to the standard six-year records maintenance with availability to the DOL, which is a standard term in class exemptions, under the Proposal these records would also have to be made available, upon request, to:
• the Internal Revenue Service or another state or federal regulator;
• any fiduciary of a Plan invested in an Investment Fund managed by the QPAM;
• any contributing employer and any employee organization whose members are covered by a Plan invested in an Investment Fund managed by the QPAM; or
• any participant or beneficiary of a Plan invested in an Investment Fund managed by the QPAM.
The DOL certainly is entitled to access records pertaining to the exemption, but extending that availability to the public, without the protections available under the Freedom of Information Act, has the potential to open up a Pandora’s box. While certain exceptions are made for privileged trade secrets, privileged commercial or financial information, or information identifying other individuals, in order to rely on these exceptions, within 30 days of the request the QPAM must provide a written notice advising the requestor of the reasons for the refusal and that the DOL may request such information by the close of the thirtieth (30th) day following the request. It is unclear whether this means that the DOL believes it has the authority to access privileged and confidential information, and if so, will be obligated to protect that information from public disclosure. For large organizations in particular, the 30-day window is an extremely short timeframe and coordinating responses could take time away from important investment management duties.
Objective: “Updating asset management and equity thresholds in the definition of “Qualified Professional Asset Manager.”
Proposal: Equity and net worth thresholds for banks, savings and loan associations and insurance companies would be increased to $2,720,000. For investment advisors, total client assets under management would increase to $135,870,000, with shareholders or partners’ equity increased to $2,040,000. All of these numbers would be subject to annual inflation adjustments.
As is the case with many other provisions of the Proposal, this provision is problematic because it does not provide relief for existing arrangements with current managers. There are bound to be QPAMs that fall within the window between the old requirements and the updated ones. A similar situation arises with the cost-of-living adjustments. In both situations, a plan might find itself losing out on a trusted manager or beneficial investment fund on very short notice. Comments to the DOL on the Proposal are due by September 26, 2022, which is 60 days after publication of the Proposal.