The ERISA Advisory Counsel has devoted one of its study projects this year to issues surrounding the prohibited transaction rules and hedge funds (and also cross-trading). The basic problem, as the study group has framed it, is that the Department of Labor's plan asset regulations characterize the underlying assets of a hedge fund as plan assets if immediately after the most recent aquisition of any equity interest in the fund, more than 25% of the equity is held by benefit plan investors. (This is a slight but for our purposes irrelevant simplification of the actual rule.) So significant investments by plan investors make the otherwise largely unregulated hedge funds subject to ERISA regulation. Being subject to ERISA regulation can make it difficult for a hedge fund to operate, particularly in complying with the prohibited transaction rules. (It should be said, contrary to the belief of some, that the plan asset regulations do not use the term "hedge fund.")
The study group held two days of testimony. The first day was largely given over to representatives of groups that favor changing the plan asset regulations in a way that would allow more plan investors to hold interests in a hedge fund without the hedge fund being subject to ERISA regulation. (The Pension Protection Act of 2006 has already softened the impact of the plan asset regulations, but retains the 25% threshold, although with a more limited definition of plan investor.) The witnesses argued that hedge funds can be an acceptable plan investment, that the regulations' treatment of hedge funds was different than its treatment of certain venture capital and real estate asset pools, that hedge funds were subject to state law and federal securities fraud laws, and that the plan-asset regulations were promulgated almost two decades ago and that there has been a sea change in the investment universe since then.
On the second day of testimony, there were at least two witnesses who were somewhat skeptical of the desirability of changing the plan asset regulations to accommodate greater plan investments in hedge funds. Ironically, the second day of testimony occurred on the day after Amaranth announced it had lost three billion dollars of its investors' money. I was one of the skeptical witnesses. (Damon Silvers was another.)
I thought I would use this blog to expand the audience for my testimony from the advisory council members and the few outside attendees to the perhaps the slightly larger and only slightly overlapping world of readers of this blog. I stipped the testimony of its first paragraph (the one saying how I am the author of articles and books and teach at the University of Alabama and am a visiting professor at Vermont Law School), but reproduce the rest of my testimony below (including a few paragraphs on the other topic the study group was looking at: cross-trading). Although the hedge fund issue has a number of interesting aspects, I am particularly interested in thoughts about what plans, if any, should be investing in hedge funds, and when and for what purpose.
Anyway, here is the testimony (double-spaced no less):
I appreciate the opportunity to testify before you today on the important topics that this work group is studying: the plan asset regulations, and particularly how they affect the ability of employee benefit plans to participate as investors in hedge funds; and cross-trading. It is also always a pleasure to testify before the advisory council, something that I think is especially true for those of us who are advisory board alumni
I should mention up front that my comments today are my own and in no way reflect the views of the University of Alabama, which I should add has won, although not in convincing fashion, its first three football games of the season.
Vermont Law School does not have a football team, but it does have its own wonderful tradition of
stunning fall foliage.
I mentioned that it is a pleasure, as an advisory council alum, to offer you my comments today. But it is even more of a pleasure to appear before you with an opportunity to play the role of Old Testament prophet, railing against the abandonment of the first and second of ERISA’s fiduciary commandments:
First, honor the principle that where there is an opportunity for fiduciaries or parties-in-interest to exploit a conflict of interest, some will do so; and
Second, recognize, always, that some fiduciaries will do really dumb stuff unless the law makes it really hard to do really dumb stuff.
These two commandments lead me to conclusions about each of the topics you are studying today:
On cross-trading, there is room for a thoughtful expansion of the ability of investment professionals dealing with plan assets to use cross-trading to benefit the plans, but generally speaking, only for large plans that have the resources and sophistication to protect their interests;
On the plan asset regulations, do not change one iota of the current plan asset regulations to accommodate ERISA plan investment in hedge funds. And I don’t say this just because Amaranth, the hedge fund, might be worth less today than Amaranth, the cereal I had for breakfast this morning. I say it because it is not a good idea, at least not now, to tinker with the regulations, especially since the Pension Protection Act has already done some tinkering and we should give that tinkering time to cure.
Let me begin with some general observations about ERISA fiduciary law and ERISA investing—not the most common ideas, such as ERISA’s adoption of modern portfolio theory, and in particular, the benefits of diversification and the notion of total portfolio design as the proper context for judging prudence. Those ideas are generally understood by sophisticated ERISA practitioners and scholars and have already been invoked by some of the other witnesses that have appeared before you.
But one idea that is too infrequently articulated and often not fully appreciated is that with employee benefit plans, it is better to have rules that protect most plans against the possibility of large loss than rules that accommodate speculative or even innovative investment strategies that might produce above-market gains for some plans. Departures from this principle can be disastrous for the participants in employee benefit plans.
Another important idea that is sometimes overlooked, and that has some congruence with the “large loss” concern, is that ERISA plans come in varying sizes and ERISA fiduciaries and service providers with varying degrees of sophistication. Rules that might be good with respect to one type of plan (a large plan, for example, utilizing the investment skills of highly regarded and experienced professionals) may not be good with respect to another type of plan (a small plan, for example,. that does not have easy access to sophisticated investment advice).
With those two principles in mind, I am almost ready to turn to the topics at hand. But I want to make one additional preliminary point: my thoughts on the plan asset regulations reflect not only ERISA concerns, but also some general concerns about hedge funds and investment markets generally.
Let me begin with cross-trading. Cross-trading has obvious advantages to ERISA plans: it can reduce trading expenses. It is, of course, true that over the last several years increased competition, industry innovation, and a DOL-supported fiduciary focus on plan expenses, have substantially lowered trading costs for plans. So today there is less low-hanging fruit to be harvested through the use of cross-trading. But having said that, cross-trading, subject to appropriate regulatory constraints, can still save some plans money.
But cross-trading has costs as well. Let me mention three obvious costs:
1. Cross-trading can result in a favorable price to one party at the expense of another.
2. Cross-trading can result in investment managers causing a plan to sell or purchase assets in order to facilitate a trade with another plan, rather than to advance the plan’s own investment strategies.
3. Cross-trading can delay consummation of buy or sell transactions and thus lose the benefit of the market price at the time the buy/sell decision was made by the plan fiduciary.
Obviously, practices that implicate the first two costs would be illegal under ERISA’s general fiduciary rules, but the general fiduciary rules are not as strong a deterrent to such practices as the prohibited transaction rules.
Large plans are equipped to protect themselves from illegal costs and to minimize the overall costs of cross-trading. I suspect that many small plans are not in such a position. Thus, any liberalization of cross-trading should create two regulatory regimes, one for larger plans, and one for smaller plans. The regime for smaller plans should reflect likely aggregate gains and losses for small plans on the whole: better to impose modest additional costs on those small plans that have the ability to protect themselves from improper or unnecessary cross-trading costs than to impose such costs on plans that cannot protect themselves. (Perhaps to cross-trade for smaller plans, an entity facilitating the cross-trades should be required to hire one or more independent fiduciaries to monitor its practices.)
In addition, those professionals that facilitate cross-trading for plans should be required to provide client plans information about cross-trading on a regular basis, to allow the appropriate plan fiduciaries to monitor actual practice to ensure that the benefits exceed the costs.
2. The Plan Asset Regulations and Hedge Funds
I am skeptical that this is the appropriate time to revisit the interaction between the plan asset regulations and hedge funds. For one thing, we have just seen yet another hedge fund absorb yet another spectacular loss in a moment’s time. For another, Congress itself just liberalized the plan asset regulations in a way that will increase the opportunities for ERISA plans to invest in hedge funds. Given this, prudence alone dictates that we wait a decent interval before expanding still further the invitation for hedge funds to pursue ERISA plan investors. Lets wait to see what happens from Congress’s liberalization before yet still further liberalization.
Here are some reflections on why the 25% plan investor threshold should not, at least at this time, be increased. (Indeed, I think a compelling case could be made to reduce rather than increase the threshold.)
1. I am skeptical of hedge funds as suitable investments for most investors, in part because of their lack of transparency, which is related to their immutability to the normal registration and disclosure rules applicable to most other securities. To me, a hedge fund is a magic box: put your money in one end and out the other end comes dollar after dollar. It is true that some funds have claimed spectacular returns, but other funds have lost almost unfathomable amounts of money. And I suspect—and this is only conjecture—that some of the large gains earned by some funds have come from two sources:
First, the normal rules of chance—if you make large bets, you will win some of the time but over the long haul you will also lose some of the time. Today’s winners look great, but two years from now they might not. This was certainly the case for Long Term Capital Management and Amaranth.
Second, from inflated valuations of illiquid properties held by some hedge funds. This may be the next great scandal waiting to happen, when we learn that many hedge funds did not generate mega returns after all. Without more regulation, we cannot be certain that some of the amazing rates of return on investment have not been mere paper returns. This may be the hedge fund equivalent of cooking the books.
2. Hedge funds might, as some of your earlier witnesses have suggested, offer risk/return characteristics that can improve a plan’s overall portfolio. This may be true, but if so, it is probably true only for, or primarily for, large defined benefit plans. Any change in rules that applies to plans generally will inevitably result in the assets of smaller plans finding their way into some hedge funds.
3. To paraphrase W. P. Kinsella, if more plan capital can be invested in hedge funds, there will be more hedge funds. And if there are more hedge funds, there will be more lower-quality hedge funds, including some that are run by people who are not Nobel Prize laureates and perhaps some that are run by people spiritually linked to Tony Soprano. And as certain as night follows day, these funds will end up with the assets of some employee benefit plans. Moreover, a proliferation of hedge funds may have an unpredictable effect on capital markets, as they attract more capital away from more traditional investments.
4. One might have special concerns about so-called fund of funds, which is an umbrella fund that then purchases interests in actual hedge funds. As I understand it, the appeal of hedge funds is that they offer unique investment strategies that can help plans hedge certain types of risk or that promise to provide high returns at low risk (now there’s a concept for you). Given this, it is hard to see how a fund of funds would ever be a prudent investment. Presumably, a hedge fund is a good investment if the particular fund fits the particularized needs of a particular plan’s portfolio. A fund of funds is not a particular fund, and its appropriateness to a portfolio, and its value, will be extremely hard to assess. Plus, funds of funds subject plans to two sets of fees and expenses. Yet some of these funds already attract ERISA capital, and if the plan asset regulations are made more flexible they will attract still more ERISA capital.
5. Some witnesses have likened hedge funds to other “alternative” investments, i.e., real estate and venture capital pools. But there is an important distinction between these investment vehicles and hedge funds: we know that these pooled investments are investing in real things: actual businesses or actual real property, not exotic swaps and large bets on currency fluctuations or the size of tiny expected spreads between related indexes. Investors know what they are investing in with real estate and venture capital, at least more or less. With hedge funds, investors know less and have less ability to judge the bona fides of a particular investment strategy, especially where the strategy is “proprietary” and not fully disclosed.
Indeed, plans may often find that their investments in a hedge fund are merely investments in the purported genius of its individual managers, a dangerous investment strategy. And other plans may find that they are simply chasing last year’s spectacular returns.
(It is also important to observe that venture capital pools are not exempt from the plan-asset regulations unless the pool is in fact actively involved in the management of at least one of the businesses in which the pool has invested.)
6. More hedge funds will mean more capital diverted from clearly productive use to bets on what will happen to the spread between March and April heating oil futures contracts. This may not be a good trend to encourage by opening wider the ERISA doors to hedge fund investments.
7. Although this point may have been obliquely made in some of the earlier points, many small plans simply do not have the sophistication to evaluate hedge fund offerings; they will be the prey of the marketers of the lower quality funds that will almost certainly be released into the marketplace if the plan asset regulations are relaxed.
8. The current administration has championed defined benefit funding policies that would subtly encourage plans to develop portfolios in which assets more closely match plan liabilities, i.e., portfolios that are rich in secure fixed income securities that match the duration of plan liabilities and thus substantially tamp down interest-rate risk. Inviting new plan investment in hedge funds seems curiously inconsistent with this policy.
9. For those hedge funds that are subject to ERISA, ERISA shines the most regulatory light on what are otherwise fairly secretive investment vehicles. For those who believe in either transparency, or on the strongest constraints on the behavior of those who handle the retirement savings of other people, dimming that regulatory light may be problematic.
10. Hedge funds may offer spectacular returns but sometimes return spectacular losses. To return to one of my original points: for pension plans, it is better to have a rule that prevents some plans from experiencing devastating losses, even if it freezes the ability of a few plans to chase spectacular returns. This is not to say that high-income investors should stay away from hedge funds; only that pension plans, which cannot afford large losses, should generally stay away from hedge funds.
There is always pressure to weaken ERISA’s fiduciary rules, to believe that the better angels of our nature are sufficient, in and of themselves, to restrain the self-interest of those who are entrusted to manage the retirement savings of other people. We tend, as we look back at those wise men and women who drafted ERISA’s elaborate fiduciary protections (both in Congress and in the Executive branch), to think that they just didn’t realize that strict and sometimes unyielding constraints on fiduciary behavior has costs to plans. But of course they realized this. But they also realized that weaker, more flexible rules have costs as well.
In 1974, and in the early part of ERISA’s regulatory history, they determined that those latter costs were too high for an enterprise that is attempting to ensure adequate retirement savings for millions of working men and women. Evolution is a slow process and human nature has not, so far as I can discern, evolved to a more angelic level since 1974, at least in the worlds of finance, investment management, and business. The judgments made in ERISA’s early days were not, of course, perfect, and we should enjoy the freedom today to adjust them when we are certain that the benefits of adjustment outweigh the costs of adjustment. But that freedom should be leavened with a heavy responsibility, and the responsibility is to make sure that we know that those benefits outweigh those costs.
Making it easier for fiduciaries to engage in cross-trading of the assets of plans that have the ability to protect themselves from the costs of cross-trading is consistent with that responsibility. Making it easier for ERISA plans to invest in hedge funds, or put another way, weakening the protections that ERISA plans enjoy when they invest in hedge funds, is not consistent with that responsibility.
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