Credit fund managers face unique conflicts issues under ERISA that require specific policies and procedures designed to identify, avoid and mitigate the risks these conflicts pose. This podcast serves as an introduction to how credit fund managers should approach some of the common and emerging scenarios and misconceptions surrounding ERISA, including season and sell, loan participations, venture capital operating company designations and transacting in secondary markets.
This is the first in a series of podcasts featuring discussions of market trends and common issues related to credit funds.
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Jessica O’Mary: Hello, and welcome to the first podcast in a series of podcasts focused on issues related to credit funds. My name is Jessica O'Mary, and I am a partner at Ropes & Gray in our investment funds practice, with a particular focus in the credit funds industry. Joining me today is Josh Lichtenstein a partner in our tax and benefits group who focuses on ERISA and employee benefit matters. Today we'll be discussing with Josh the features of ERISA that impact credit fund managers and how to navigate a few issues that are relevant for those managers.
Jessica O’Mary: Josh, what do you see as the most important thing for credit fund managers to know about ERISA?
Josh Lichtenstein: ERISA is fundamentally about identifying and avoiding or mitigating conflicts of interest between ERISA fiduciaries and the plans they work with. The primary way that these conflicts can be mitigated is through having policies and procedures to identify and resolve these conflicts, and making sure that they are followed. For credit funds, the most common conflicts that we see are those where our credit manager is on multiple sides of the same transaction. ERISA prohibits cross trades, but cross trades are conceived of under ERISA much more broadly than they are other purposes, and so any transaction where the same manager is managing multiple mandates on the buy and sell side, or otherwise on opposite sides of the transaction it is potentially going to be cross trade under ERISA that would be prohibited. So season and sell, or other types of syndication transactions, are a common example of a transaction that a credit fund may engage in, that may create an issue under ERISA.
Jessica O’Mary: So, Josh, it sounds like other similar situations that might raise issues that are common with credit fund managers may be loan participations, or shared S.P.V.s below the fund. Is that correct?
Josh Lichtenstein: That's correct. Anytime that you have a transaction where the manager is representing an ERISA mandate, and another mandate, whether or not that second mandate is an ERISA mandate, and their transacting with each other, that is where these issues are raised, and where these concerns may be present. The other common conflict that we see is when a manager that has multiples mandates that are both invested in the same capital structure has to make a decision about whether or not to exercise rights on behalf of the ERISA mandate. This can happen if you have an ERISA mandate that holds senior debt securities, and another mandate ERISA or not that holds junior debt securities, or where you have one mandate holding debt securities, and one mandate holding equity securities at the same company. In these situations, the concern that would be raised is where you have to determine whether to exercise rights that the ERISA mandate has with respect to its securities. And those rights may have a different impact on the ERISA mandate versus the other mandates that also hold in the capital structure. And the conflict that would be of concern, and must be mitigated, is any situation where the manager could be viewed as having taken into accountant the impact of those decisions on the mandates as a whole, not just making a decision to act in a matter that's in the best interest of the ERISA mandate.
Jessica O’Mary: Are there any common misconceptions in the marketplace about ERISA issues for credit funds?
Josh Lichtenstein: There are a few. The first one is that you'll often hear people say that credit funds can’t be exempt from ERISA as venture capital operating companies, or V.C.O.C.s. Generally in order to be a V.C.O.C. and so be exempt from ERISA, you need to have a fund that is investing primarily into operating companies, and which possesses certain management rights with respect to those operating companies. While it can be more difficult to manage to negotiate these management rights as a credit fund, particularly when investing outside of the U.S. where people may be less familiar with the requirements of ERISA, and so may be less familiar with seeing these management rights requests. But credit funds are not precluded from being V.C.O.C.s, and it's actually quite common for mezzanine debt funds to qualify as V.C.O.C.s, particularly where they're also taking some small equity position in a company along with the debt, and are able to negotiate management rights with respect to both investments. Another common misconception is that credit funds cannot make use of realization-based waterfalls in determining how they're incentive allocation will work. In general under ERISA, an ERISA fiduciary is prohibited from having control over the timing or the amount of their fee. And so realization-based waterfalls can create a conflict, because the manager has the ability to determine when to sell an investment, and at what price. And so there are concerns that if they were to use that discretion in order to generate a fee for themselves at a time that is advantageous to them, but may not be in the best interest of the ERISA mandate, than that would be a prohibited transaction under ERISA. But this does not necessarily apply to a credit fund, because a credit fund could have a realization-based waterfall, where the realization events are just the collecting of interest payments it's entitled to with respect to its debt holdings. If you have a strategy where the majority of the income being received is just from holding these securities, as opposed to buying and selling the securities before maturity, then it may not be a problem under ERISA to use a realization-based waterfall.
Jessica O’Mary: Are there any recent developments that credit funds should be aware of?
Josh Lichtenstein: ERISA is always evolving, and there are a couple of relatively recent developments that are of particular interest to credit funds. First is the issues of ERISA restricted securities. There are certain securities that are generally traded, not on public markets, but traded through fairly robust secondary markets where the offering documents may have originally stated that ERISA investors are not permitted to participate in certain of the securities that are offered. When an asset manager is given the opportunity to buy these securities on the secondary market, you know, through Bloomberg or some other secondary market maker, they may not necessarily have access to the original offering documents, and they may also not have good visibility into whether those documents contained any sort of ERISA related restriction. And the parties facilitating these transfers generally will not tell you whether a security is a ERISA restricted or not. And so if you're buying a debt security, that's being traded on a secondary market, it's important to obtain the original offering documents and review them, to make sure that the specific security you're buying does not contain a restriction from being held by ERISA investors. If you were to hold such a security in an ERISA account, then you could be subject to fines from the department of labor, and you could also have to make the plan whole for any losses that it incurs, even if absent the explicit language saying that it's not a security that's eligible for ERISA investors, you would have viewed as otherwise being an appropriate investment for the ERISA investor. The other major recent development is the department of labor's fiduciary role. This is a complicated topic, and without going into a lot of detail, the department of labor fiduciary role has broadened the range of activity that will cause a manager to be considered a fiduciary to an ERISA plan. This means that a lot of activity that would traditionally be thought of as marketing or sales activity, can actually be viewed as fiduciary investment advice, that a plan should invest into the asset manager's fund. This can be the case even if the fund that they invest in does not ultimately itself hold plan assets. To protect against this risk, it's important to review marketing materials, including pitch books, and to talk with your sales force to make sure that they're aware of the changes under the rule, and understand what they can and cannot say if they do not want to become fiduciaries under ERISA.
Jessica O’Mary: Thank you, Josh. That is all the time we have today. Thank you for listening, and for more information, please refer to the handout attached to this podcast, and visit our website at www.ropesgray.com. Stay tuned throughout the coming months for more news and analysis concerning credit funds issues.