The Department of Labor (DOL) recently announced that it has brought an action against an investment manager who invested ERISA clients' money into a hedge fund and received a portion of the incentive fees earned by the hedge fund's manager. In addition it appears that the hedge fund's manager had an interest in the investment manager who directed its clients into the hedge fund.
If true, such transactions would appear to involve self dealing prohibited transactions and breaches of fiduciary duty under ERISA. The potential liabilities for the investment manager are significant and the manager's principals could be subject to personal liability in connection with these transactions. A prohibited transaction, in effect, gives the investing plan a rescission right; consequently the plan would have a right to be put into the same position by the investment manager as it would have been in had it never made the investment. Therefore, to the extent there have been any losses as a result of the investment in the underlying fund, the manager and its principals could be liable to reimburse any such losses to the investing ERISA plans. The investment manager would also be required to return to each ERISA plan its portion of the fees the investment manager received from the underlying fund's manager and the investment manager could incur significant excise taxes attributable those fees. In sum, the potential liabilities of the investment manager attributable to these transactions would be (i) losses incurred by the ERISA plans in connection with these investments (even if the losses are a result of a general market drop), (ii) returning to the ERISA plans the portion of the fees the investment manager received from the underlying fund attributable to those plans, and (iii) excise taxes calculated on those fees. In addition, there could also be personal liability for the investment manager's fiduciaries who elected to invest in the underlying hedge fund to make up those losses if the investment manager has insufficient assets or insufficient ERISA fiduciary insurance.
The DOL appears to be increasing its oversight of investment managers. Any investment manager who is an ERISA fiduciary (such as one managing separate accounts of ERISA investors or a manager of a fund with at least 25% of its interests held by benefit plan investors) should carefully review arrangements with anyone with whom it is affiliated or from whom it is receiving compensation, to determine if there are potential ERISA issues.