Under normal circumstances, credit fund managers that invest retirement plan money face multiple fiduciary and conflict of interest issues under ERISA that require special attention. These issues have been amplified by the current global health emergency and related economic crisis. In this Ropes & Gray podcast, asset management partner Jessica O’ Mary and ERISA & benefits partner Josh Lichtenstein address how credit fund managers that invest on behalf of ERISA accounts can navigate some of these legal challenges as they arise in the current climate.
Jessica O’Mary: Hello, and thank you for joining us today on this Ropes & Gray podcast. My name is Jessica O'Mary, and I’m a partner at Ropes & Gray in our investment funds practice, and the head of our credit funds practice. Joining me today is Josh Lichtenstein, a partner in our tax & benefits group who focuses on ERISA and employee benefit matters, and who has extensive experience advising credit funds that operate under ERISA. In past podcasts, we have spoken about certain issues that credit fund managers face under ERISA, and today, Josh and I will be revisiting these issues ERISA can create for credit fund managers, but this time in the context of the COVID-19 pandemic that we’ve all been dealing with and resulting economic crises. Josh, I have heard you describe in the past ERISA as a process-based rule in terms of what a fiduciary to an ERISA plan must do in acting on behalf of plan participants and their beneficiaries. Can you elaborate on that and what it means right now in particular?
Josh Lichtenstein: Thank you, Jessica. When acting as an ERISA fiduciary, a manager must discharge its responsibilities “with the care, skill, prudence and diligence” that a prudent person “acting in a like capacity and familiar with such matters” would use. This is often referred to colloquially as a prudent expert standard. The Department of Labor has consistently stated that complying with this standard requires diligence of process, but not necessarily a guarantee of the best results. From the ERISA fiduciary’s perspective, it is critical that in these trying times, the fiduciary continues to maintain its investment and decision-making process and that it continues to document it. This means that a fiduciary must continue to perform diligence and monitoring of investment performance and of the service providers it engages to assist with investment management and other services for its ERISA plan clients.
Jessica O’Mary: Josh, that makes sense in the abstract, but what steps would you suggest that a fiduciary take to show their compliance while working remotely and dealing with so much disruption in the market?
Josh Lichtenstein: I think that a manager should be proactive with these monitoring responsibilities, making sure to among other things: (i) regularly check in over the phone or in writing with any of the service providers it relies on for handling its ERISA accounts, such as subadvisers or administrators to ensure that they are still able to provide all of the services they normally provide and to keep written records of all of the monitoring check ins with these service providers, (ii) its also important to recalibrate the ERISA accounts’ investments if the facts and circumstances indicate that changes are warranted and may be carried out within the constraints of the mandate, and (iii) thoroughly document all actions the manager takes in a response to a disruption like COVID in real time (including any recalibration of investments), such as by taking minutes and keeping meticulous and organized records of the decision-making process. I cannot emphasize enough the importance of taking these steps and documenting them in real time—even if it requires taking extra steps such as convening more frequent meetings of the investment professionals and other decision-makers responsible for overseeing these ERISA accounts because you want to demonstrate that each ERISA account was considered on its own in light of the circumstances.
Jessica O’Mary: Thanks Josh, that’s helpful. In the same vein, I assume these ideas of monitoring and communication also entail more frequent interactions between managers and the investment committees and other fiduciaries of the plan sponsors themselves?
Josh Lichtenstein: That’s generally going to be right. Although the main onus for communication and checking in is going to be on the plan sponsor of the ERISA plan, it is a good idea to communicate with your ERISA clients to establish that they are aware of and have not objected to any actions that you’re taking in response to a market disruption like COVID, especially if you are making changes in strategy or investment focus for an account. Even if you are authorized to take these types of steps or actions on your own under the fund or account documents, it’s still a good idea to communicate with clients in advance so that the fiduciary to the plan understand the shifts being made if the investment process or investment profile will be materially different than it was before the disruption. For example, if a fund has target ranges for asset classes but the documents allow investment outside of the targets and the manager plans to shift strategy away from those soft targets, it is a good idea to establish through written communication that the investor understands that the fund will not be following those targets, at least during this period.
Jessica O’Mary: Josh, shifting gears slightly, as we have discussed in past podcasts, ERISA is very focused on avoiding conflicts of interest. Why are conflicts of interest such a significant issue under ERISA, and how could the current market disruption caused by COVID-19 potentially trigger ERISA conflicts for credit fund managers?
Josh Lichtenstein: This is probably the biggest question for credit fund monitors. At a fundamental level, ERISA is concerned with identifying and avoiding or mitigating conflicts of interest between ERISA fiduciaries and the plans they’re working with or for. This means that for the fund manager, it is required to act in the ERISA account’s best interest when it is making decisions on behalf of that account—it cannot give consideration to the manager’s other accounts or the manager’s own interests. Anytime there is the potential for the interests of the manager or of the manager’s other accounts to diverge from the interests of the ERISA account, you should be thinking about potential conflicts under ERISA.
For credit funds specifically, these issues most commonly arise when a manager has multiple mandates that are both invested in different portions of the same capital structure and the manager has to make a decision about whether or not to exercise rights on behalf of an ERISA mandate. While this scenario may seem hypothetical—with many companies facing the prospect of having to either file for bankruptcy, modify their capital structures or renegotiate credit agreements with lenders, these risks of potential ERISA conflicts are becoming real and that risk has become heightened.
For example, you could have a situation where an ERISA mandate holds senior debt securities in a company entering bankruptcy, and another much larger mandate of the same manager (whether ERISA or not) holds junior debt securities. The manager will need to make decisions on behalf of the ERISA mandate with respect to the senior debt, but the manager could be viewed as having taken into account the impact of those decisions on the mandates as a whole, not just making a decision to act in a manner that is in the exclusive best interest of the ERISA mandate that holds the senior. A more complicated scenario that could play out in the current environment would be where multiple mandates hold the same security in a company and then their interests diverge due to a renegotiation of the original security in part, or a subsequent debt issuance that only certain accounts invest in. In cases like this, the facts will need to be examined in detail, and documentation of the investment rational for any actions taken (or foregone) by the ERISA accounts will need to be vetted and documented in writing as we discussed before. It won’t always be possible to resolve these types of conflicts through process and documentation though, and the stakes are high because these types of conflicts could result in prohibited transactions under ERISA or breaches of fiduciary duties and that could impose liability on the manager or require the manager to disgorge fees. Managers may need to forego investments, change allocations or even bring independent fiduciaries in to make decisions in the most difficult of these cases.
Jessica O’Mary: Josh, it seems as though these types of issues could come up much more frequently in the current environment, especially for stressed distressed debt strategies. Should managers try to avoid managing plan assets if they want to follow these strategies that are likely to result in conflicts or how would you think about that issue?
Josh Lichtenstein: This is a great question, Jessica. There’s no class of investments that is per se inappropriate for ERISA investors and many plans are showing increased interest in the distressed sector and other related areas now because like other investors, they seem to want to take advantage of potential market dislocations. I think that managers should feel that they can take on these mandates, but it is very important to create an environment within the manager which features plans for how to address these conflicts. For example, by ensuring that accounts will invest pari passu by identifying investments that might cause more of a potential for conflicts in the future and in considering whether you should hold them or sell those assets out of an ERISA account, or by creating some separation in terms of investment process for the ERISA fund and the manager’s other funds, you can have plans that are in place in advance to help deal with these types of issues. Information walls can also be helpful in this regard for some managers depending on their size. Documentation of separate diligence and investment committee decisions with respect to ERISA accounts is also very helpful and really of key importance here.
Jessica O’Mary: Josh, part of the interest we are seeing now from ERISA investors is in funds that will invest in asset-backed securities as part of the new Term Asset-Backed Securities Loan Facility program, or TALF. Are there special ERISA considerations that may prevent ERISA plans from investing in these types of funds?
Josh Lichtenstein: Well, the structure of those types of investments as asset-backed security investments generally does not raise many of the concerns that we discussed earlier for direct lending or direct investing strategies. Certain asset-backed securities are restricted from being held by ERISA plans by their terms, so it is important to review the offering documents to ensure that ERISA funds can participate in each investment. As a practical matter, since the TALF program is limited to highly-rated securities, these types of restrictions should not appear often.
Jessica O’Mary: So it sounds like even though the parameters of the TALF program are still being worked out, that we can continue to see a lot of activity and interest from ERISA investors in the current environment. If there is no safe harbor or clear rule on addressing conflicts, what are some practical steps credit fund managers can take to identify and mitigate potential conflicts of interest when they manage ERISA accounts in this environment?
Josh Lichtenstein: There are a number of reasonable steps that a manager can take to be proactive and avoid potential conflicts of interest under ERISA. While you are right that there is no safe harbor or “silver bullet” solution, by combining multiple approaches, a manager can construct a defensible position for dealing with conflicts. Here are some examples of some of the reasonable steps a manager could take:
- Establish ongoing monitoring for situations that may lead to conflicts. By ensuring monitoring for potential conflicts of interest when any account makes an investment that could require decisions to be made on the opposite side of an ERISA account, you can make sure that you are catching these potential conflicts as they arise.
- You can have ERISA accounts hold pro-rata interests with other accounts. Generally, conflicts are less likely to arise when ERISA accounts hold the same securities as other accounts on a pro-rata basis because the interest should be the same.
- You can look at the direction that the rights and conflicts run in. Conflicts of interest are generally more likely to arise in situations where the ERISA account holds the senior position and so may have to make decisions that can actually influence the value of other accounts of the manager than where the ERISA account doesn’t have the ability to take actions on its own that influences outcomes. Even though this may be counterintuitive because the default in many cases would clearly be to just protect senior interests, these types of concerns really come up when you’re negotiating a prepackaged bankruptcy or taking actions that are intended to rescue the company (and thereby risking the current value that the senior interests would otherwise obtain). And these are real concerns that really do need to be watched for, in particular, in situations like this where some more creative steps may be taken to try and rescue companies.
- It’s also helpful to be mindful of investment timing. In general, a problem is more likely to arise under ERISA where an ERISA account makes an investment after another account already holds a position. For example, if a non-ERISA account holds a senior position and a new junior tranche is offered, it could be viewed as the ERISA account providing support for the value of the existing debt by “rescuing” it by making the investment.
- Managers should also watch for tipping points. Even if action by an ERISA account alone would not be able to create a benefit to another account of the manager, you should consider whether action by the ERISA account in a block with other accounts of the manager would cause the same result. For example, if an ERISA account’s interest pushes the total holdings across accounts of the manager into a majority position, that could raise a conflict because the ERISA account’s investment would in part we could find potentially significant economic right on other accounts of the manager.
- Finally, it’s important to issue spot, educate yourself and document. Make sure the relevant internal personnel are sensitive and educated to the accounts that are ERISA so that all relevant personnel can raise questions and issue spot in advance of a potential problem being created. And as we discussed throughout this podcast, you should document in real time your decision-making process and how the decisions that are being made are being made in the interests of the ERISA account specifically.
Jessica O’Mary: That’s very helpful, Josh. So far, we’ve largely been discussing issues as they relate to accounts and funds that are managed as ERISA plan assets. One last point I wanted to discuss applies to those managers who instead rely on one of the exceptions from having to comply with the ERISA fiduciary rules, for example, managers who limit participation by ERISA investors in their funds by twenty-five percent. What should those fund managers be thinking about right now?
Josh Lichtenstein: This is an important point because the current market disruption has caused many ERISA plans (and other investors) to look for greater liquidity in their portfolios. As a result, it’s conceivable that under some circumstances, if enough non-ERISA investors seek to redeem their interests and withdraw from a fund, then a fund that was previously below the twenty-five percent threshold could be pushed over and inadvertently become an ERISA plan asset vehicle. Therefore, it will be important for fund managers to find ways to offer liquidity to investors who are looking to withdraw, while at the same time, continuing to be mindful of the level of participation of ERISA LPs in a fund to make sure that they’re not breaching the significant participation test or they don’t intend to.
Jessica O’Mary: Thanks, Josh. That’s all the time we have today. Thank you so much for joining us. For more information on the topics that we discussed or other topics of interest to the asset management and credit funds communities, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of the topics we discussed today, please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening and take care.
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