Analysis: Imagining a World without QPAM

This article was written by Jeffrey Ross and Andrea L. Pollak (also available at friedfrank.com).

By now, most stakeholders are aware that the Department of Labor proposed an amendment to the QPAM exemption over the summer that would significantly expand the conditions for compliance. The industry is currently commenting on the proposal, and the DOL intends to hold a public hearing on November 17, after which there will be a supplementary 14-day comment period. Based on the comments submitted to date, it seems most agree that the proposal is deeply flawed. In what could be an historic first, both SIFMA and the NCCMP (the National Coordinating Committee for Multiemployer Plans—not necessarily a natural ideological ally of the asset management industry) agree that their first choice would be for the DOL to scrap its proposal entirely. Many of the comment letters are extensive and erudite. But perhaps a short letter from Representatives Foxx and Allen sums it up best in observing, "[t]he proposed amendment would seem to be a solution in search of a problem[.]"

Many of the comments do an admirable job of dissecting the proposal in detail, identifying the numerous interpretive and logistical challenges presented. As just one example of how a seemingly innocuous provision might wreak havoc on the market, the proposal would add language that, in the DOL’s view, would eliminate any possible confusion regarding the extent to which a party in interest may be involved in a transaction. To this end, the DOL states, "[n]o relief is provided under this exemption for any transaction that has been planned, negotiated, or initiated by a Party in Interest, in whole or in part, and presented to the QPAM for approval." This addition appears to be motivated by the classic "rent-a-QPAM" concern. But the language is so broad that it could arguably prohibit many routine and completely innocuous transactions (e.g., independent broker-dealer calls asset manager to suggest it consider a particular trade). Similar regulatory overreach infects numerous other aspects of the proposal. The list of concerns is lengthy and serious.

So what is driving the DOL here? Billed as a "modernization" effort, the top two rationales listed in the adopting press release were "[a]ddressing perceived ambiguity as to whether foreign convictions are included in the scope of the exemption’s ineligibility provision" and "[e]xpanding the ineligibility provision to include additional types of serious misconduct." But, of course, the proposal goes well beyond these two headline items. There are some clues sprinkled throughout the preamble that shed some light on the underlying biases that seem to be driving the DOL’s efforts. An examination of these clues reveals, however, that the DOL’s "solutions" are likely unwarranted; there is nothing so broken as to require such a radical fix.

The DOL’s frustration with the proliferation of individual exemption requests driven by affiliate convictions seems to be a primary driver. The preamble refers to basic integrity concerns and notes the importance of organizations maintaining a "culture of compliance." In this regard, the DOL states that "[f]oreign crimes of the sort described in the proposed amendment call into question a firm’s culture of compliance just as much as domestic crimes." Further, "in the [DOL]’s view, QPAMs and those in a position to influence or control a QPAM’s policies that repeatedly engage in criminal conduct or other egregious misconduct in connection with compliance with the conditions of the exemption do not display the requisite standards of integrity to rely on the relief provided in the exemption."

Any ERISA fiduciary must maintain a high standard of integrity, but even organizations with best-in-class cultures of compliance cannot guarantee that one person sitting at an overseas subsidiary that has no overlap with a QPAM’s business or the management of ERISA plan assets will not become a bad actor. Further, including crimes and misconduct by far-removed affiliates of the QPAM punishes large, multi-national organizations, which one might argue tend to be the best equipped to be ERISA fiduciaries and QPAMs. In fact, the DOL itself expressed the view in its 1982 proposed exemption that large financial services institutions are precisely the types of institutions that can best withstand improper influence from parties in interest. Forty years later, however, the marquee aspect of the DOL’s proposal seems to evidence a basic lack of understanding of how large organizations actually function in practice.

Similar to the "culture of compliance" point, the preamble states, "[b]ecause the [DOL] relies upon the QPAM as a key protection against … improper conduct and the threat posed by conflicts of interest, it is critically important that the QPAM, and those who are in a position to influence its policies, maintain a high standard of integrity." (emphasis added) Of course, the QPAM exemption by its terms does not apply to true ERISA conflict of interest transactions (i.e., the exemption does not apply to self-dealing conflict of interest transactions described in Section 406(b) of ERISA). It appears then that the "conflict of interest" to which the DOL is referring is the theoretical concern that parties in interest have the ability to unduly influence routine financial services transactions with ERISA plans.

The DOL’s statement here is unfortunately based on one of ERISA’s fundamental fallacies—that parties in interest who are mere counterparties to a plan are in a position to unduly influence plans and how they transact. The notion that counterparties (particularly those that are large financial services institutions and the most typical beneficiaries of the QPAM exemption) would routinely be abusing ERISA plans but for the protections of ERISA’s prohibited transaction regime has always been highly questionable, and one of the most reviled aspects of the statute. In fact, as financial services institutions have become more heavily regulated, the type of nefarious conduct imagined by Congress in 1974 (and perhaps by the DOL still today) seems even less likely to occur. This realization was behind the fundamental shift in regulatory approach that Congress seemed to promise in enacting the statutory service provider exemption in 2006. The service provider exemption recognized that ERISA’s categorization of counterparties as parties in interest was overly protective of plans and needlessly deprived plans of access to beneficial transactions (or at least unduly increased the cost of transacting). It is strange, then, that the DOL is choosing to take a step backwards towards increased complexity in compliance, despite the most recent expression of congressional intent.

These concerns about integrity and compliance culture ultimately lead the DOL to a curious place. The DOL seems to suggest that some of its changes may be driven less by a desire to promote technical compliance with the exemption (or with the prohibited transaction regime generally), and more by a desire to regulate how asset managers market themselves to plan clients. That is, the DOL appears to view QPAM eligibility as mark of "integrity" and wants to restrict the designation by making it harder to maintain. Specifically, the preamble states that, "according to … past applicants, if an entity is no longer able to represent that it is a QPAM, client [p]lans are far less likely to retain the QPAM as their manager, even in situations where the client technically does not need the relief provided by the exemption." (emphasis added) Why is the DOL proposing to regulate how asset managers market themselves? And what does this have to do with avoiding prohibited transactions?

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There is still some hope that the DOL will reconsider significant portions of its guidance in light of the comments to date and the upcoming hearings. But it is still interesting to consider how the market might react if the proposed amendments were to be adopted in anywhere near their current state.

While it is possible that some will adapt to the new regime, this conclusion does not seem assured in all cases. One’s view of the challenges presented by the proposal will likely depend on the segment of the market in which they operate. For example, large managers of long only products trading liquid equity securities on the open market might find it relatively easy to comply with some of the added requirements. On the other hand, alternative asset managers, particularly those focusing on less liquid strategies, will likely have more difficulty.

In this context, some of the proposal’s signature additions relate to procedures for winding down a manager-client relationship upon an manager’s failure to maintain QPAM eligibility, including a related requirement to indemnify clients. These may be especially difficult to integrate for many alternative asset managers, particularly those investing in less liquid strategies. By definition, less liquid assets cannot always be exited in a timely way and, therefore, the proposed one year wind down period may be impracticable, if not impossible, for these strategies. Similarly, manager indemnification of clients is not nearly as common in the alternative investment space as it is in the long only market. Agreeing to an indemnity, even if unlikely to be called upon, is something that institutions that think about risk holistically take very seriously. If there is even a perception that the potential cost of agreeing to an indemnity is too great, it could cause institutions to want to exit the space entirely.Another possibility is that asset managers and other financial services institutions move away from reliance on the QPAM exemption, and instead rely on other exemptions, such as the service provider exemption. Immediately following its enactment, many in the industry shied away from relying on the service provider exemption because of uncertainty regarding its application. However, despite some potential interpretive issues, acceptance of the service provider exemption has been steadily increasing, particularly following the DOL’s comments in the preamble to PTCE 2006-16.[1]

For an alternative asset manager, the viability of relying on the service provider exemption in lieu of the QPAM exemption would depend first on ERISA clients being comfortable with their assets being managed by entities that may very well qualify as QPAMs but are not willing to comply with the DOL’s new requirements (the curious marketing point raised by the DOL above), and second on whether financial institution counterparties will accept representations and covenants around the asset manager’s compliance with the service provider exemption rather than the QPAM exemption. Of course, the "service provider exemption only" approach would be complicated in the case of funds and accounts investing in cleared derivatives, where the DOL has limited its regulatory relief to QPAMs and INHAMs. If the market were to move to increased reliance on the service provider exemption, it would call into question the utility of the DOL’s QPAM modernization effort.

Finally, another likely outcome is that some asset managers cease managing ERISA plan assets entirely, at least with respect to certain product offerings. If this were to occur, ERISA plans would no longer have the opportunity to participate in many beneficial niche economic opportunities. Or, if they are able to participate, their exposure would likely be through non-plan asset vehicles. These vehicles, of course, would be unregulated by ERISA and the applicable manager would not be required to act in accordance with the ERISA standard of care in managing them. This outcome seems completely at odds with the DOL’s stated goal of protecting plans.

So, if this proposal were adopted, some very likely outcomes include that asset managers would have to accept the new regime and live with the increased costs of compliance, reject the new regime and begin relying on exemptions other than QPAM, or perhaps reject the new regime by exiting certain market segments entirely (or begin offering certain products in a way that is not regulated by ERISA). Given these possibilities, one might ask if the regulated community would indeed be better off were the DOL to take SIFMA’s and the NCCMP’s advice.